Introduction To Micro Economics: Economics and BCK Notes

Economics and BCK Notes
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INTRODUCTION TO MICRO ECONOMICS

The word ‘Economics’ originates from the Greek word ‘Oikonomia’ which means
household. It is divided into two parts.
1. Oikos which means house
2. Nomia which means management.
Thus, Economics means house management. Economics is based on the concept of
self-interest.
It is based on two fundamental facts that
a) Human beings have unlimited wants and
b) Resources (means) are scarce and they have alternative uses.
Thus, Economics is study of allocation of resources in such a manner that (at the micro
level) the individuals are able to maximize their gains and (at the macro level) the
society is able to maximize its social welfare.
DEFINITION OF ECONOMICS
Wealth related definition–

Adam smith is known as father of Economics. He wrote a book. “An enquiry into the
nature and causes of wealth of Nations” which is popularly known as “Wealth of
Nations” in 1776.
Adam Smith defines Economics “A science which studies the nature and causes of
wealth of Nations”.
According to J.B. Say – “Economics is a science which deals with wealth” According to
F.A. Walker “political Economy or Economics is the name of that part of knowledge
which relates to wealth”.
According to F.A. Walker “political Economy or Economics is the name of that part of
knowledge which relates to wealth”.
CS SOMYA KATARIA (CS, MBA) 9131993373 1.1

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Features –
• Importance to the creation of wealth in an economy. The classical economists
believed that economic prosperity of any nation depends only on the
accumulation of wealth.
• These definitions show that economics also deals with an inquiry into the
causes behind the creation of wealth.
• The term ‘wealth’ does not have a universally accepted meaning.
Criticism: -
a) Ignored creation of immaterial Wealth like services of a doctor, lawyer, CA etc.
b) Ignored social welfare
Science of material well-being “Welfare definition: -

Alfred Marshall defines Economics as “political Economy or Economics is the study of
mankind in ordinary business of life. Thus, it is on the one side study of wealth and
on the other and important side a part of the study of the man”. Alfred Marshall
published his book ‘Principles of Economics’ in 1890.
Features: -
1. These definitions indicate that economics studies only the material aspects of
well-being.
2. These definitions show that economics deals with the study of man in the ordinary
business of life. Thus, economics enquires how an individual gets his income and
how he uses it.
3. These definitions stressed on the role of man in the creation of wealth or income.
Criticism: -
• It ignores creation of immaterial wealth like services of doctors, C.A., teachers etc.
• Very difficult to state which things would lead to welfare and which will not.
Science of choice making –

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“Lionel Robbins” wrote a Book “An essay on the Nature and significance of Economic
science” in1931. He defines economics as- “Economics is the science which studies
human behavior as a relationship between ends and scarce means which have
alternative uses” –
Criticism: -
1. Concept of welfare is not explicitly mentioned.
2. The definition makes economics a human science instead of social science.
3. The definition is narrow and restricted in scope. It does not talk about economic
growth or economic development. It is impersonal and colorless.
4. Rational decision-making requires that one’s choice be consistent with one’s goals.
It fails to deal with what is good or bad for society’s welfare and what should be
done to attain good ends.
Science of Dynamic Growth and development: - Paul A. Samuelson

"Economics is the study of how men and society choose, with or without use of money,
to employ scarce productive resources which could have alternative uses, to produce
various commodities over time and distribute them for consumption now and in the
future amongst various people and groups of society." He wrote a book ‘Economics:
an introductory analysis’ which was first published in 1948. – PAUL A. SAMUELSON
BUSINESS ECONOMICS
Business Economics may be defined as the use of economic analysis to make business
decisions involving the best use of an organization’s scarce resources.
NATURE OF BUSINESS ECONOMICS
MICRO-ECONOMICS
It analyses the economic behavior of an individual, firm or industry in the national

economy.

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1. “Micro-economics is the study of particular firms, particular households,

individual price, wages, income, individual industries and particular
commodities” – Prof.Boulding.
2. Micro-economic studies –
a) Product pricing
b) Consumer behavior
c) Economic Conditions of a
Section of the People
d) Factor Pricing
e) Study of firms
f) Location of a Industry.
MACRO-ECONOMICS
a) It is the study of the overall economic phenomena or the economy as a whole,

rather than its individual parts.
b) It analyzes the behavior of national aggregates including national income,

aggregate consumption, savings, investment, total employment, general price
level, & country’s balance of payment.
c) Macro Economics studies –
• National Income & Output;
• General price Level;
• Balance of Trade & Payment
• External value of Money;
• Saving & Investment;
• Employment & Economic
Growth

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Nature of Business Economics

Business Economics is a Science:
Business Economics integrates the tools of decision sciences such as Mathematics,
Statistics and Econometrics.
Based on Micro Economics:

A business manager takes decisions in order to ensure the long- term survival and
profitable functioning of the organization.
Incorporates elements of Macro Analysis:

A business unit does not operate in a vacuum. It is affected by the external
environment of the economy in which it operates such as, the general price level,
income and employment levels in the economy and government policies with
respect to taxation, interest rates, exchange rates, industries, prices, distribution,
wages and regulation of monopolies.
Business Economics is an art

as it involves practical application of rules and principles for the attainment of set
objectives.
Use of Theory of Markets and Private Enterprises:

Business Economics largely uses the theory of markets and private enterprise.
Pragmatic in Approach:
Business Economics is pragmatic in its approach as it
practical problems which the firms face in the real world.
Interdisciplinary in nature:
Business Economics is interdisciplinary in nature as it incorporates tools from
other disciplines such as Mathematics, Operations Research, Management Theory,
Accounting, marketing, Finance, Statistics and Econometrics.
Normative in Nature:
Economic theory has developed along two lines – positive and normative. A
positive or pure science analyses cause and effect relationship between variables
in an objective and scientific manner, but it does not involve any value judgement.
In other words, it states ‘what is’ of the state of affairs and not what ‘ought to be’.

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It is descriptive in nature in the sense that it describes the economic behaviour of

individuals or society without prescriptions about the desirability or otherwise of
such behaviour.
A normative science involves value judgements. It is prescriptive in nature and

suggests ‘what should be’ a particular course of action under given circumstances.
Welfare considerations are embedded in normative science.
Example of positive science:

a) Planned economies allocate resources via government departments.
b) Most transitional economies have experienced problems of falling output and
rising prices.
c) There is a greater degree of consumer sovereignty in the market.
d) Faster economic growth should result if an economy has a higher level of
investment.
e) Higher levels of unemployment will lead to higher level of inflation.
f) The average level of growth in the economy was faster in the 1980s.
g) Analysis of the relationship between the price and quantity demanded. (Law of
demand)
Example of normative science:

a) Reducing inequality should be major priority for mixed economy.
b) Changing the level of interest rates is a better way of managing the economy than
using taxation and government Expenditure.
CENTRAL ECONOMIC PROBLEMS
The central economic problem may be of four types:

1. What to produce?

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2. How to produce?
3. For whom to produce?
4. What provision should be made for economic growth?
What to produce: –
Quantum of goods means how much of different goods to be produced. The guiding
principle is to allocate resources in a way that generates maximum aggregate utility.
How to produce: -
This problem is related to the choice of technique for producing a commodity. An
economy has to choose between
a) Labour intensive technique-Under this technique, production depends more
on use of labour.
b) Capital-intensive technique-Under this technique, production depends more

on use of machines.
For whom to produce: -

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Problem of "for whom to produce" means how the national product i.e., national
income is to be distributed among the factors of production that helped to produce it.
What provision should be made for Economic Growth: -
TYPES OF ECONOMIES
Market Economy or capitalist Centrally Planned Economy or

Economy Command Economy
It is a free economy where central It is an economy under control of the

problems are solved by the forces of government. Supply and demand forces
supply and demand in the market. are regulated or controlled by the
government.
There is no limit to private ownership of Private ownership of property is under

property. The owners of the productive scanner of the government. Ceiling on
factors like land, factories, machinery the ownership of property may be
are under private ownership. They are imposed to reduce the gulf between the
free to use them in the manner they like. rich and the poor. [Note: in a fully
planned economy, also called command
economy, (of which there is not example
of present) private ownership of
property is not allowed at all.]
Maximisation of profit is the principal Maximisation of social welfare is the

objective of production activity. principal objective of production activity
Growth of the economy is left to the Growth of the economy proceeds

market forces. according to the planned programmes
(as Five-Year Plans in India)
There is no direct participation of the The government plays on active role in

government in the process of the process of production.
production.

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TYPES OF ECONOMIES
In a mixed economy the aim is to develop a system which tries to include the best
features of both the controlled economy and the market economy while excluding the
demerits of both. It appreciates the advantages of private enterprise and private
property with their emphasis on self-interest and profit motive.
Features of a mixed economy
Co-existence of private and public sector

a) Private sector
b) Public sector
Combined sector
Existence of Economic Planning: Allocation of resources in a mixed economy

should be better since it attempts to combine the productive efficiency of
capitalism and distributive justice of socialism.

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Administered Price: In a mixed economy, a dual system of pricing exists. In

private sector, prices of goods & factors of production are determined through the
free play of market forces demand and supply. In public sector, the state
determines prices of various products.

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CHAPTER – 2
THEORY OF DEMAND AND SUPPLY
DEFINITION OF DEMAND
a) Demand refers to the quantities of commodity that the consumers are able to buy
at each possible price during a given period of time, other things being equal.
[Fergusons]
b) Demand is the ability and willingness to buy specific quantity of a good at
alternative prices in a given time period, ceteris paribus. [B.R Schiller].
c) Three things are essential for a desire for a commodity to become effective
demand.
• Desire for a commodity
• Willingness to pay
• Means to purchase i.e. Ability to pay for the commodity.

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DETERMINANTS OF DEMAND
a) Ceteris Paribus i.e. other things being constant, Demand

Price of the
is inversely related to price.
Commodity
b) This happens because of income & substitutions effect.
a) Complementary Goods e.g. Pen & Ink Price of one good

Prices of Related decreases, Demand of other good increases and vice
Commodities versa.
b) Substitute Goods or competing goods e.g. Tea & Coffee
Price of one Good decreases, Demand of other good
decreases and vice versa.
a) Average Money Income , Demand of Normal good ↓,

Level of Income
of the Household b) Exception: Inferior goods
Average Money Income , Demand of Inferior good ↓
Favorable change in taste & Preference increases demand

Unfavorable change in taste & Preference decreases
demand.
Taste &
Preference of ‘Demonstration effect’ or ‘bandwagon effect’: An
Consumer individual’s demand for LCD/LED television may be affected
by his seeing one in his neighbor’s or friend’s house.
SNOB EFFECT: A person may develop a taste or preference

for wine after tasting some, but he may also develop it after
discovering that serving it enhances his prestige. On the
contrary, when a product becomes common among all, some
people decrease or altogether stop its consumption. This is
called ‘snob effect’.

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VEBLEN EFFECT: Highly priced goods are consumed by

status seeking rich people to satisfy their need for
conspicuous consumption.
This is called ‘Veblen effect’ (named after the American
economist Thorstein Veblen). In any case, people have tastes
and preferences and these change, sometimes, due to
external and sometimes, due to internal causes and
influence demand.
If the consumers expect increase in future prices, increase in

Consumer income and shortages in supply, more quantities will be
expectation demanded. If they expect a fall in price, they will postpone
their purchases of nonessential commodities and therefore,
the current demand for them will fall.
a) Size of the Population- larger the size of population,

Other Factors
greater is the demand.
b) Composition of population- if there are more old people
in a region, demand for spectacles, walking sticks will be
high.
c) The level of National Income and its Distribution: Higher
the national income, higher will be the demand for all
normal goods and services. The wealth of a country may
be unevenly distributed, the propensity to consume of
the country will be relatively less. Hence, demand will be
less. If the distribution of income is more equal, then the
propensity to consume of the country as a whole will be
relatively high indicating higher demand.
d) Consumer-credit facility and interest rates: Availability

of credit facilities, more demand. less credit facilities, less
demand. Low rates of interest, more demand. high rate of
interest, higher demand Apart from above, factors such
as government policy in respect of taxes and subsidies,
business conditions, wealth, socioeconomic class, group,

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level of education, marital status, weather conditions,

salesmanship and advertisements, habits, customs and
conventions also play an important role in influencing
demand.
Definition by Prof.Alfred Marshall
defined the Law thus: “The greater the amount to be sold, the smaller must be the
price at which it is ordered in order that it may find purchasers or in other words the
amount demanded increases with a fall in price and diminishes with a rise in price”.
Meaning:
According to the law of demand, other things being equal, if the price of a commodity
falls, the quantity demanded of it will rise and if the price of a commodity rises, its
quantity demanded will decline. Thus, there is an inverse relationship between price
and quantity demanded, ceteris paribus.
Assumption:
Law of demand holds goods when “other things remain the same” meaning thereby,
the factors affecting demand, other than price, are assumed to be constant.

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Demand Function:
Where,
• Dx = Demand for Commodity

• Px = Price of Commodity
• X Pr = Price of other goods
• Y = Income of the consumer
• T = Taste and preference
• E = Expectation of the consumer
DEMAND SCHEDULE

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DEMAND CURVE
WHY DOES DEMAND CURVE SLOPES DOWNWARD?
a) Law of diminishing marginal utility-

according to this law as consumption of a commodity increases, the utility from
each successive unit goes on diminishing to a consumer. Accordingly for every
additional unit to be purchase, the consumer is willing to pay less and less price.
Thus, more is purchased only when our price of the commodity falls.
b) Income effect-
It refers to change in quantity demanded when real income of the buyer changes
as a result of change in price of the commodity, with a fall in price real income of
the consumer increases and demand for the commodity expands.
c) Substitution effect-
It refers to substitution of one commodity for the other when it becomes
relatively cheaper. Thus, when price of commodity X falls it becomes cheaper in
relation to commodity Y. Hence, X is substituted for Y. This is called substitution
effect.
d) Size of consumer group-

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e) When price of commodity falls it attracts new buyers who can now afford to pay
for it and hence the demand increases.
f) Different uses –
Many goods have alternative uses say for eg: milk is used for making curd, cheese
and paneer. If price of milk reduce it will be put to different uses and demand for
milk will expand.
EXCEPTIONS TO LAW OF DEMAND
Conspicuous consumption:
These goods are also known as articles of prestige value or snob appeal or articles of
conspicuous consumption. It was found out by Veblen in his doctrine of “conspicuous
consumption” and hence known as Veblen effect or prestige goods effect. According
to him articles of distinction have more demand only if their prices are sufficiently
high.
Eg. Diamond jewellery, costly carpets etc. Ignorance: Sometimes, consumers out of
sheer ignorance or poor judgment consider a commodity to be low quality if its prices
is low and of high quality if its price is high.
Giffen goods:
These goods are those goods which have positive price effect and negative income
effect. Positive prices effect means that demand falls with a fall in price and rises with
a rise in price. These are highly inferior goods showing a very high negative income
effect.
The demand for certain goods is affected by the demonstration effect of the
consumption pattern of a social group to which an individual belongs. These goods,
due to their constant usage, become necessities of life.
For example, in spite of the fact that the prices of television sets, refrigerators,
coolers, cooking gas etc. have been continuously rising, their demand does not show
any tendency to fall.

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Expectations:
If prices are likely to rises more in the future, then even at the existing higher prices
people may demand more units of the commodity in the present and vice versa.
In the speculative market, particularly in the market for stocks and shares, more will
be demanded when the prices are rising and less will be demanded when prices
decline.
EXPANSION AND CONTRACTION IN DEMAND
Movement along a demand curve

Refer to change in quantity demanded of a commodity in response to change in own
price of a commodity, other things remaining constant. It is expressed by different
point on the same demand curve and moving from 1 point to the other on the same
demand curve is called movement along demand curve. It has two expects
• Expansion of demand- It occurs when quantity demanded increases in response
to fall in own price of the commodity.
• Contraction of demand- It occurs when quantity demanded decreases in
response to rise in own price of the commodity.

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INCREASE AND DECREASE IN DEMAND ORSHIFT IN DEMAND

CURVE
Shift in demand curve-

Refers to all such situations when demand for a commodity increases or decreases
due to changes in other determinants of demand other than own price of the
commodity. It has two aspect-
• Increase in demand- A situation when demand curve shifts to right is known as
increase in demand or forward shift in demand curve. (When more is purchased
at the same price of the commodity).
• Decrease in demand- A situation when demand curve shifts to left is known as

decrease in demand or backward shift in demand curve. (when less is purchased
at the same price of the commodity).
ELASTICITY OF DEMAND
MEANING OF ELASTICITY OF DEMAND

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a) Elasticity of Demand answers the question “BY HOW MUCH?” (It is a quantitative
concept)
b) Elasticity of demand is defined as the responsiveness of the change in quantity
demanded of a good due to change in one of the variables on which demand
depends.
% 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐃𝐞𝐦𝐚𝐧𝐝𝐞𝐝

E=
% 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐨𝐧𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐕𝐚𝐫𝐢𝐚𝐛𝐥𝐞𝐬 𝐨𝐧 𝐰𝐡𝐢𝐜𝐡 𝐃𝐞𝐦𝐚𝐧𝐝 𝐝𝐞𝐩𝐞𝐧𝐝𝐬
• The Elasticity of Demand is a pure number.
TYPES OF ELASTICITY OF DEMAND
i. PRICE ELASTICITY OF DEMAND

Meaning of Prices Elasticity of Demand,
it is measured as a percentage change in quantity demand divided by the
percentage change in price, other things remaining constant.
DETERMINANTS OF PRICE ELASTICITY OF DEMAND

i. Nature of Commodity:
Necessaries like salt, kerosene oil, matchboxes, textbooks, seasonal
vegetables, etc. have less than unitary elastic (inelastic) demand, Luxuries, like
air-conditioner, costly furniture, fashionable garments, etc; have greater than
unitary elastic demand, Comforts like milk, transistor, cooler, fans, etc., have
neither very elastic nor very inelastic demand. Jointly demanded goods, like
bread and butter, pen and ink, camera and film, ordinarily show a moderate
elasticity of demand.
ii. Availability of Substitutes:

Demand for goods which have close substitutes (like, tea and coffee, being
close substitutes of each other) is relatively more elastic. Because, when price
of such a good rise, the consumers have the option of shifting to its substitute.

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Goods without close substitutes like cigarettes and liquor, are generally found
to be less elastic in demand.
iii. Diversity of Uses:

Commodities that can be put to a variety of uses have elastic demand. For
instance, electricity has multiple uses. It is used for lighting, room-heating, air
conditioning, cooking, etc. If the Price of electricity increases, its use may be
restricted only to important purposes like lighting. On the other hand, if a
commodity such as paper has only a few uses, its demand is likely to be less
elastic.
iv. Postponement of Use:

Demand will be elastic for goods, the consumption of which can be postponed.
v. Income Level of the Buyer:

Elasticity of demand for a good also depends on the income level of its buyers.
If the buyers of a good are high-end consumers (with high level of income)
they will not be bothered by a rise in its price. Accordingly, elasticity of
demand is expected to be low. E.g. Demand for luxury cars by the multi-
billionaires. If income level of the buyers of a good is low, elasticity of demand
is expected to be high. Eg. Demand for small cars by the middle-class people
in India.
vi. Habit of Consumers:

Goods to which consumers become accustomed or habitual will have inelastic
demand like cigarette and tobacco.
vii. Proportion of Income Spent on a Commodity:

Goods on which consumers spend a small proportion of their income
(toothpaste, boot polish, newspaper, needles, etc.), will have an inelastic
demand. Goods on which the consumers spend a large proportion of their
income (cloth, scooter, etc.), tend to have elastic demand.
viii. Price Level:

Elasticity of demand also depends on the level of price of the concerned
commodity. Elasticity of demand will be high at higher level of the price of the
commodity and low at the lower level of the price.

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ix. Time period: Demand is inelastic in short period but elastic in long period. It
is because, in the long run, a consumer can change his consumption habits
more conveniently than in the short period.
POINT ELASTICTY OF DEMAND

a) It refers to measuring the elasticity at a particular point on demand curve.
b) It makes use of derivative changes rather than finite changes in price &quantity.
INCOME ELASTICITY DEMAND

Meaning of Income Elasticity of Demand Income elasticity of demand is the degree of
responsiveness of quantity demand of a good to a small change in the income of
consumer.
Where,
Y = original money income
ΔY = change in money income
Q = original demand
ΔQ = change in change in demand
Degree of Income Elasticity of Demand
1. a) Income Elasticity of Demand for a good is positive, when with an

increase in the income of a consumer, his demand for the good
increases and vice versa.

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b) It is Positive in case of Normal Goods.
2. a) Income elasticity of demand is negative when increase in the income

of the consumer is accompanied by fall in demand of a good.
b) It is Negative in case of Inferior Goods.
3. a) Income elasticity of demand is zero, when change in the income of
consumer evokes no change in his demand.
b) Demand for Necessities like oil, salt, etc. have zero income elasticity
of demand.
CROSS ELASTICITY OF DEMAND

a) Meaning of Cross Elasticity of Demand
Cross Elasticity of Demand is a change in the demand of one good in response to a
change in the price of another good.
Where,
Ec = Cross Elasticity:
qx = Original Q.D. of X
qx = Change in Q.D. of X : py = Original Q.D. of Y
py= Change in price of Y
b) Degrees of Cross Elasticity
Positive cross elasticity of demand
• It is positive in case of substitute goods

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• For example, rice in the price of coffee will lead to increase in demand for
tea.
• The curve slopes upward from left to right.
Negative cross elasticity of demand
• It is negative in case of complementary goods.

• For example, rice in the price of bread will bringdown the demand for tea.
• The curve slopes downward from left to right.

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Zero cross elasticity of demand
• Cross elasticity of demand is zero, when two goods are not related to each other.
• For example, rice in the price of wheat will have no effect on the demand for
shoes.
If two goods are perfect substitutes for each other cross elasticity is infinite and if two
goods are totally unrelated cross elasticity between than is zero.
TOTAL EXPENDITURE (OUTLAY) METHOD
1) This method was evolved by Dr. Alfred Marshall.

2) According to this Method, to measure the elasticity of demand it is essential to
know how much & in what direction the total expenditure has changed as a result
of change in the price of a good.
Advertisement Elasticity
a) Advertisement elasticity of sales or promotional elasticity of demand is the
responsiveness of a good’s demand to changes in firm’s spending on advertising.

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b) The advertising elasticity of demand measures the percentage change in demand

that occurs given a one percent change in advertising expenditure.
c) Advertising elasticity measures the effectiveness of an advertisement campaign in

bringing about new sales.
d) Advertising elasticity of demand is typically positive.
e) Higher the value of advertising elasticity greater will be the responsiveness of

demand to change in advertisement.
f) Advertisement elasticity varies between zero and in-nity It is measured by using

the formula;
Change in demand%
Ea% =
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 𝑜𝑛 𝑎𝑑𝑣𝑒𝑟𝑡𝑖𝑠𝑖𝑛𝑔
∆Qd ∆A
Ea = ÷
Qd A
Where ,
• ∆Qd denotes change in demand.
• ∆A denotes change in expenditure on advertisement.
• Qd denotes initial demand.
A denotes initial expenditure on advertisement. Elasticity Interpretation

Ea = 0 Demand does not respond to increase in advertisement expenditure.
Ea >0 but < 1 Change in demand is less than proportionate to the change in
advertisement expenditure.
Ea = 1 Demand changes in the same proportion in which advertisement expenditure
changes.
Ea > 1 Demand changes at a higher rate than change in advertisement expenditure.

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DEMAND FORECASTING
It is the art and science of predicting the probable demand for a commodity at some
future date on the basis of certain past behaviour patterns of some related events and
the prevailing trends in the present. Demand forecasting is not a simple guessing, but
a scientific method.
Types of forecasts
a) Macro-level forecasting deals with the general economic environment prevailing
in the economy as measured by the Index of Industrial Production (IIP), national
income and general level of employment etc.
b) Industry- level forecasting is concerned with the demand for the industry’s
products as a whole. For example, demand for cement in India.
c) Firm- level forecasting refers to forecasting the demand for a particular firm’s
product, say, the demand for ACC cement.
d) Based on time period, demand forecasts may be short-term demand forecasting

and long- term demand forecasting.
e) Short-term demand forecasting covers a short span of time, depending of the

nature of industry. It is done usually for six months or less than one year and is
generally useful in tactical decisions.
f) Long-term forecasts are for longer periods of time, say two to five years and more.
It provides information for major strategic decisions of the firm such as expansion
of plant capacity.
Demand Distinctions
it is important for us to understand the demand distinctions which are as follows:
a) Producer’s goods and Consumer’s goods:
Goods which are used for the production of other goods-either consumer goods or
producer goods themselves are called producers goods. Ex. machines, plant and

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equipment. Consumer’s goods are those which are used for final consumption. Ex.
readymade clothes, prepared food, residential houses, etc.
b) Durable goods and non-durable goods: -

Non durable goods are those which cannot be consumed more than once. Raw
materials, fuel and power, packing items etc are examples of on durable producer
goods. Beverages, bread, milk etc. are examples of non-durable consumer goods.
These will meet only the current demand.
c) Derived demand and Autonomous demand: -

The demand for a commodity that arises because of the demand for some other
commodity called ‘parent product’, ‘is called derived demand. If the demand for a
product is independent of the demand for other goods, then it is called
autonomous demand.
d) Industry demand and Company demand: -

The term industry demand is used to denote the total demand for the products of
a particular industry, e.g. the total demand for steel in the country. On the other
hand, the demand for firm’s product denotes the demand for the products of a
particular firm, i.e. the quantity that a firm can dispose o at a given price over a
period of time.
e) Short-run demand and Long-run demand: -

Short-run demand refers to demand with its immediate reaction to changes in
product price and prices of related commodities, income fluctuations, ability of the
consumer to adjust their consumption pattern, their susceptibility to
advertisement of new products etc. Long-run demand refers to demand which
exists over a long period. Most generic goods have long- term demand. Long term
demand depends on long-term income trends, availability of substitutes, credit
facilities etc.
Factors affecting demand for non-durable consumer goods:

non-durables are purchased for current consumption only
There are three basic factors which influence the demand for these goods:

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i. Disposable income
ii. Price
iii. Demography
Factors affecting the demand for durable-consumer goods:

Demand for durable goods has certain special characteristics. Following are the
important factors that affect the demand for durable goods.
• Whether a consumer will go on using the good for a long time or will replace it
depends upon factors like his social status, prestige, level of money income,
rate of obsolescence etc.
• These goods require special facilities for their use e.g. roads for automobiles,
and electricity for refrigerators and radios. The existence and growth of such
factors is an important variable that determines the demand for durable goods.
• As consumer durables are used by more than one person, the decision to
purchase may be influenced by family characteristics like income of the family,
size, age distribution and sex composition. Likely changes in the number of
households should be considered while determining the market size of durable
goods.
• Demand for consumer durables is very much influenced by their prices and
credit facilities available to buy them.
Factors affecting the demand for producer goods:

Since producers’ goods or capital goods help in further production, their demand is
derived from the demand of consumer goods they produce. Hence data required for
estimating demand for producer goods (capital goods) are:
i. growth prospects of the user industries;
ii. norms of consumption of capital goods per unit of installed capacity.
Methods of demand Forecasting

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The following are the commonly available techniques of demand forecasting:

i. Survey of Buyers’ Intentions:
The most direct method of estimating demand in the short run is to ask
customers what they are planning to buy during the forthcoming time period,
usually a year. This method involves direct interview of potential customers.
Depending on the purpose, time available and costs to be incurred, the survey
may be conducted by any of the following methods:
a) Complete enumeration method where nearly all potential customers are

interviewed about their future purchase plans.
b) Sample survey method under which only a scientifically chosen sample of

potential customers are interviewed
c) End–use method, especially used in forecasting demand for inputs,

involves identification of all final users, fixing suitable technical norms of
consumption of the product under study, application of the norms to the
desired or targeted levels of output and aggregation.
ii. Collective opinion method:

This method is also known as sales force opinion method or grass roots
approach. Under this method following steps are followed:
a) Salesmen estimate expected sales in their respective territories.
b) Consolidate these estimates of salesmen to find out the total estimated

sales.
c) Review the estimates to eliminate the bias of optimism on the part of some
salesmen and pessimism on the part of others.
d) Examine the revised estimates in the light of various factors like proposed
changes in selling prices, product designs and advertisement programmes,
expected changes in competition and changes in secular forces like
purchasing power, income distribution, employment, population, etc.

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Expert Opinion method:

The Delphi technique, developed by Olaf Helmer at the Rand Corporation of the USA,
provides useful way to obtain informed judgments from diverse experts by avoiding
the disadvantages of conventional panel meetings. Under this method. Experts are
asked to provide forecasts and reasons for their forecasts. Experts are provided with
information and opinion feedbacks of others at different rounds without revealing
the identity of the opinion provider.

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CONSUMER BEHAVIOUR
APPROACHES TO CONSUMER BEHAVIOUR

1. Cardinal Utility Approach
a) Propounded by Marshall.
b) Known as Marshallian Approach.
2. Ordinal Utility Approach

a) Propounded by Hicks & Allen
b) Known as Indifference Curve Analysis.
MEANING, FEATURES AND CONCEPTS OF UTILITY
Meaning of Utility
a) Utility is synonymous with “Pleasure”, “Satisfaction” & a sense of fulfillment of
desire.
b) Utility is “WANT SATISFYING POWER” of a commodity.

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Features of Utility
• It deals with the mental satisfaction of a man. For example, liquor has utility
for drunkard but for a teetotaler, it has noutility.
• Relative: Utility of a commodity never remains same, it varies with time, place
& person. For example, cooler has utility in summer but not during winter.
• Need not ne useful: A commodity having need not be useful. For Example,
Liquor is not useful, but it satisfies the want of an addict thus have utility for
him.
• Utility has nothing to do with ethics. Use of liquor may not be good from the
moral point of view, but as these intoxicants satisfy want of the drunkards, they
have utility.
Concepts of Utility
Relation between TU and MU
• With consumption of an additional unit of a commodity, total utility increases.

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• With consumption of an additional unit of a commodity, total utility remains

same.
• With consumption of an additional unit of a commodity, total utility decreases.
LAWS OF DIMINISHING MARGINAL UTILITY
a) The additional benefit which a person derives from a given increase in stock of a
thing diminishes with every increase, in the stock that he already has. [Marshall].
b) As the amount consumed of a good increase, the marginal utility of the good tends
to decrease. [Samuelson]
c) Law of diminishing marginal utility states that as more and more units of a
commodity are consumed, marginal utility derived from every additional unit
must decline. It is also known as Fundamental Law of Satisfaction or Fundamental
Psychological Law.
This law is based on above four assumption of the MU analysis and there are also
three more assumption:
• Taste, income of the consumer remains unchanged.
• The units of the commodity are identical in all aspects. Only standard units of
commodity are consumed.
• There is no time – gap between consumption that i.e. Consumption of
commodity should be continuous.

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MARSHALLAIN CONSUMER’S SURPLUS
a) Consumer’s Surplus= What a consumer is ready to pay – What he actually pays.

b) Derived from the law of diminishing Marginal Utility.

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1. Consumer’s Surplus cannot be measured precisely because it is difficult to

measure the Marginal utilities of different units of a commodity consumed by
a person.
2. In case of necessaries, the marginal utilities of earlier units are infinitely large.
In such cases, Consumer’s Surplus is always infinite.
3. Consumer’s Surplus deriving from a commodity is affected by the availability

of substitutes.
4. No Simple rule for deriving the utility scale of articles of distinction e.g.
diamonds.
5. Marginal Utility of money is assumed to be constant which is unrealistic

because consumer’s surplus cannot be measured in terms of money because
the marginal utility of money changes as purchases are made and consumer’s
stock of money diminishes.
 It is very important to a business firm to reflect on the amount of

consumer surplus enjoyed by different segments of their customers
because consumers who perceive large surplus are more likely to repeat
their purchases.
 Understanding the nature and extent of surplus can help business
managers make better decisions about setting prices.
 Large scale investment decisions involve cost benefit analysis which
takes into account the extent of consumer surplus which the projects
may fetch.
 Consumer surplus usually acts as a guide to finance ministers when they
decide on the products on which taxes have to be imposed and the extent
to which a commodity tax has to be raised. It is always desirable to
impose taxes or increase the rates of taxes on commodities yielding high
consumer’s surplus because the loss of welfare to citizens will be
minimal.
INDIFFERENCE CURVE

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Indifference curve
1. A single Indifference Curve shows the different combination of x and y that yield
equal satisfaction to the consumer. [Leftwitch]
2. An Indifference Curve is a combination of goods, each of which yield the same level
of total utility to which the consumer is indifferent. [Ferguson]
Rationality of Consumer –
The consumer is rational & aims at maximizing his total satisfaction.
Ordinal Utility –
Utility can be expressed ordinally i.e. consumer is able to tell total order of his
preferences.
Non-Satiety – More is preferred to Less.
Transitivity of Choice –
Means that if a consumer prefers A to B & B to C, he must prefer A to C.
Consistency of Choice –
Means that if a consumer prefers A to B in one period, he will not prefer B to A in
another period or treat them as equal.

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An Indifference Curve Schedule refers to a schedule that indicates different

combinations of two commodities which yield equal satisfaction.
a. Indifference Curve (IC) is a diagrammatic representation of indifference
schedule.
b. It is a line that shows all possible combinations of two.
c. goods between which a person is indifferent. Since all
d. the combinations provide same level of satisfaction the consumers prefer them
equally and does not mind which combination he gets.
e. It is an ordinal concept given by Hicks and Allen.
Indifference Map
 An Indifference Map represents a group of indifference curves each of which

expresses a given level of satisfaction.
 A set of indifference curve is called indifference Map.

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 The rate at which an individual must give up “good X” in order to obtain one more
unit of “good Y,” while keeping their overall utility (satisfaction)constant. The MRS
is calculated between two goods placed on an indifference curve, which displays a
frontier of equal utility for each combination of “good X” and “good Y”.
RATE OF SUBSTITUTION
Marginal Rate of Substitution (MRS) is the rate at which the consumer is prepared to
exchange goods X and Y. In the following table we can define the MRS of X and Y as
the amount of Y whose loss can just be compensated by a unit gaining of X in such a
manner that the level of satisfaction remains the same.

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CONSUMER EQUILIBRIUM
• Consumer Equilibrium will be reached when he is deriving maximum possible

satisfaction from the goods & is no position to rearrange his purchase of goods.
• The consumer’s optimum bundle is located at the point of tangency between the
budget line and an indifference curve.
1. At the Tangency Point E, the slopes of the Price Line PL Indifference Curve IC3 are
equal and IC is convex to the origin.
2. Slope of Indifference curve shows MR

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Supply
• Ceteris Paribus i.e. other things beings constant, Relative Price of the good
increases, Quantity Supplied increases.
• This happens because goods are produced by the firm to gain profits. Profit rises
when price rises.
• Price of related good (Y) increases then, Quantity supplied of commodity (X) will
decrease.
• Rise in price of related good makes it more profitable for the firm to produce and
sell. Rise in price of factors of production increases the cost of making those goods
hence less commodity is supplied at its existing price.
• Imposition of taxes on commodities increase the cost of production which reduces

the firm’s supply.
• Subsidies reduce the cost of production which increases firm’s supply.

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• Improvement in the technique of production reduces cost production, more

commodity is supplied at existing price.
• Govt. industrial & foreign policies, goals of the firm, market structure, etc.
Increase and Decrease in Supply
EXCEPTIONS TO LAW OF SUPPLY
1. The Law is supply does not apply to agricultural products whose supply is
governed by natural factors. If due to natural calamities, there is a fall in
production of wheat, then its supply will not increase however high the price may
be.
2. Social distinction goods will remain limited even if their prices rise.
3. Sellers may be willing to sell more of a perishable commodity even at a lower price.
EXPANSION AND CONTRACTION IN SUPPLY OR MOVEMENT

ALONG A SUPPLY CURVE

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INCREASE OR DECREASE IN SUPPLY OR SHIFT IN SUPPLY CURVE
Quantity Supplied (at all prices) due Quantity Supplied (at all prices) due
to change in other factors Rightward to change in other factors Leftward
shift shift

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Cause of Increase in supply–

1. Decrease in price of related goods.
2. Decrease in factor price (cost of production).
3. Improvement in technology.
4. Favorable Govt. policy (decrease in taxes and increase in subsidy).
5. Future expectation about decreases in price.
6. Others
Causes of Decrease in supply –

1. Increase in price of related goods.
2. Increase in factor price (cost of production)
3. Outdated technology.
4. Unfavorable Govt. policy (Increase in taxes and increase in subsidy)
5. Future expectation about Increase in price.
6. Others
ELASTICITY OF SUPPLY
Elasticity of supply is defined as the responsiveness of the quantity supplied of a good

to change in its price. It is a quantitative concept.
TYPES OF ELASTICITY OF SUPPLY

Price Elasticity of Supply
Meaning of price Elasticity of Supply
Elasticity of supply is defined as the responsivess of the quantity supplied of a good

to change in one of the variables on which supply depends.

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Degrees of Price Elasticity of Supply
Perfectly Elastic Supply
1. A Perfectly elastic supply is one in which there is a significant change in the

supply of commodity without any change or little change in its price.
2. It is an imaginary concept. It practical life, there is no commodity, the supply of
which is perfectly elastic.

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Perfectly Inelastic Supply [E = 0]

• Perfectly inelastic supply is one which a change in price produces no change in
the quantity supplied.
• It is an imaginary concept. In Practical life, there is no commodity, the supply

of which is perfectly inelastic.
Unitary Elastic Supply [E =1]

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Unitary elastic supply is one in which a % change in price produces an equal %change
in quantity supplied.
Greater than unitary elastic supply - [E>1]

Greater than unitary elastic supply is one in which a given % change in price
produces relatively more % change in supply. As Elasticity increases, the slope
of supply Curve decreases and hence the Shape of Supply Curve goes on
becoming more flatter.
Less than Unitary Elastic (E < 1)

Less than Unitary Elastic supply is one in which a given % change in price produce
relatively less% change in quantity supplied.
As Elasticity decreases, the slope of supply Curve increases and hence the Shape of
Supply Curve goes on becoming more Steeper.

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POINT ELASTICITY OF SUPPLY
• It refers to measuring the elasticity at a particular point on supply Curve.

• It makes use of derivative changes rather than finite changes in price & quantity
supplied.
ARC ELASTICITY SUPPLY

When elasticity is to be found between 2 prices, we use are elasticity.
Where,
p1 = Original Price
q2 = Original quantity supplied
p2 = New price.

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Q2 = New quantity Supplied
FACTOR AFFECTING ELASTICITY OF SUPPLY
• Nature of inputs used-

If commonly available inputs are used, supply will be elastic.
• Natural constraints-
If we wish to produce more teak wood, it will take years of plantation before it
becomes usable. Supply of teak wood will be less elastic.
• Risk taking-
If entrepreneurs are willing to take risk, supply will be more elastic.
• Nature of commodity-
Perishable goods are less elastic than durable goods because of limited shelf life of
perishables.
• Cost of Production-
Supply will be less elastic in case increase in production causes a substantial
increase in cost of production.
• Time factor-
Longer the time period, greater will be the elasticity of supply.
• Technique of Production-
Supply will be less elastic in case production of a commodity involves the use of a
complex & expensive technology.
Equilibrium Price
Equilibrium refers to a market situation where quantity demanded is equal to
quantity supplied. The intersection of demand and supply determines the equilibrium
price. At this price the amount that the buyers want to buy is equal to the amount that
sellers want to sell. Only at the equilibrium price, both the buyers and sellers are
satisfied. Equilibrium price is also called market clearing price. The determination of

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market price is the central theme of micro economic analysis. Hence, micro-economic
theory is also called price theory. The following table explains the equilibrium price.

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CHAPTER 3
THEORY OF PRODUCTION AND COST
THE CONCEPT OF PRODUCTION AND FACTORS OF PRODUCTION
Production
• According to James Bates and J.R. Parkinson " Production is the organized activity
of transforming resources in to finished products in the form of goods and services
and the objective of production is to satisfy the demand of such Transformed
Resources".
• In Economics, Production is any economic activity, which is directed at the
satisfaction of human wants.
• Production = Creation of Utility, i.e. creation of want-satisfying goods and services.
• Production = Creation or Addition of Value, in the form of goods and services.
• Examples:
a) Production of Cars by a Manufacturer,

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b) Selling of Vegetables by a Vendor,

c) Work of Service Providers like Doctors, Lawyers, Teachers, Actors, Dancers,
etc.
Production = Creation of Utility
The major processes by which Utility can be created / added for gaining satisfaction
are -
Item Description
a) Form Utility refers to physically changing the form of natural
Form Utility
resources.
b) Manufacturing Processes generally consist of converting and
transforming a Raw Material into some final products which
possess utility.
c) Example: Making Tables & Chairs from Wood, Making
ornaments from Gold, Silver, etc.
a) Changing the place of the resources, from the place where
they are of little or no use, to another place where they are of
Place Utility
greater use is called Place Utility.
b) Place Utility can be obtained by –
• Extraction from earth, e.g. removal of coal, minerals, gold
and other metal ores from mines and supplying them to
markets.
• Moving or distributing goods from places of production
(Origin Centres) to Markets (Destination Centres)
a) Time Utility is created by making goods and services

Time Utility
available at times when they are not normally available.
b) Example: (a) Storing harvested food grains for use till next
harvest, (b) Canning of seasonal fruits to make them available
during off season.

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• Personal Utility involves making use of personal skills in the

Personal
form of services.
Utility
• Example: Doctors, Chartered Accountants, Interior
Decorators, Event Organizers, etc.
So, Production = Creation of Form Utility or Place Utility or Time Utility or Personal
Utility or all the four utilities together.
Factors of Production
• Factors of Production = Productive Resources required to produce goods and / or

services. They are classified as under –
a) Natural Resources, (this is called Land)
b) Human Endeavour, (classified into - (i) Labour, (ii) Capital, and (iii)
Entrepreneurial Skills / Ability.)
• Types: The Factor of Production, and the rewards / remuneration / incentive

thereof are
Land
Meaning:
In Economics, Land refers to all free gifts of nature. This includes soil and earth's
surface, natural resources, fertility of soil, water, air, natural vegetation, etc.
Features of Land:
a) Land is a free gift of nature.
b) Land is fixed in quantity. The Supply of Land is perfectly inelastic from the
viewpoint of the entire economy. However, it is relatively elastic from the
viewpoint of an Individual Firm.
c) Land is permanent. It cannot be destroyed or lost.

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d) Land has certain inherent properties which are original and indestructible.
The production power of soil is indestructible since its fertility can be
restored, even if it gets depleted after some use.
e) Land lacks mobility in geographical sense. It cannot be shifted from one place
to another place.
f) Land is a specific factor of production in the sense that it does not yield any
result unless human efforts are employed.
g) Land varies in fertility and uses. No two pieces of land are exactly alike in all
respects.
Labour
Meaning:
a) 'Labour' refers to mental or physical exertion directed to produce goods or

services, and with a view to gain an economic reward.
b) To have an economic significance, Labour must be done with the motive of some
economic reward. So, Activities done out of pleasure, love and affection,
pastime, hobbies, etc. although very useful in increasing human wellbeing, is not
Labour.
Features of Labour:
Aspect Explanation
• Labour involves human efforts, with a view to gain an

Human Efforts
economic reward.
• So, human and psychological considerations come up
in the context of Labour.
• Labour is 'perishable', since a day's labour lost cannot

Perishable Nature
be completely recovered subsequently. Whatever is

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lost in a day cannot be recovered wholly by extra work

on the following day.
• So, a Laborer cannot store his Labour, for use at a later
time. Hence Labour is said to have no reserve price.
• Since there is no reserve price, Labour has a weak

Weak bargaining
bargaining power.
power
• However, labour laws maintain Labour Welfare, to a
certain extent.
Self-Source
• Labour is inseparable from the Labourer himself.
• Whereas if Labour is sold, the Producer of Labour
retains the capacity to work. Thus, a Labourer is the
source of his own labour power.
• Labour may be classified as Skilled, Semi-Skilled and

Variations
Unskilled Labour.
• Labour power depends upon - (i) physical strength, (ii)
education, (iii) skill, and (iv) motivation to work.
All Labour is not productive in the sense that all efforts

Productivity
are not sure to produce want satisfying goods and
services.
• Direct Relationship: Generally, Supply of Labour and

Wage Rates are directly' related, as per general Law of
Peculiar
Supply. So, as Wage Rates increase, the Labourer tends
Relationships
to increase the supply of Labour by reducing the hours
between Labour
of leisure.
Supply and Wage
Rates • Reverse Relationship at Higher Prices: However, at a
higher level of income (wage rates), the Labourer
reduces the supply of Labour and increases the hours
of leisure in response to further rise in the wage rate.

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He may prefer to have more of rest and leisure, than

earning more money. So, Supply of Labour reduces at
very high wage rate levels.
• Reverse Relationship at Lower Prices: Similarly, when
wage rates fall below a minimum level, some more
members of the family, who were not working before,
may start working to supplement the family income.
So, Supply of Labour may also increase at very low
wage rate levels.
Land vs Capital:
Land Capital
Free gift of nature, i.e. original or Man-made or produced means of
primary. production.
Indestructible and Permanent. Perishable.
Lacks mobility in geographical sense. Has mobility.
Quantity of land is fixed and limited. Amount of Capital can be increased.
Rent from Land varies from place to Return on Capital is comparatively fixed.
place.
Types of Capital
Types of Capital Description
It exists in durable shape and renders a series of services

Fixed Capital overa period of time. For E.g. - Tools, Machines etc.

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Circulating Capital It is another form of capital which performs its function in

production in a single use and is not available for further
use.E.g.: Seeds, Raw materials etc.
Real Capital It refers to physical goods such as Building, Plant, Machines

etc.
Human Capital It refers to human skill and ability.
Tangible Capital It can be perceived by senses.
Intangible Capital It is the personal property owned by an individual or a

group of individuals.
Social Capital It belongs to society as a whole in the form of roads, Bridges

etc.
Capital Formation
Meaning:
Capital Formation –
a) means a sustained increase in the stock of real capital in a country.
b) involves production of more capital goods like Plant and Machinery,

Equipment’s, Accessories, etc. which are used for further production of goods.
c) is also known as Investment.
Need for Capital Formation:

Capital Formation or Investment is required for –
a) replacement and renovation of existing machinery and equipment, i.e.
Increasing the efficiency of production efforts, and
b) creating additional productive capacity, i.e. expansion of output of consumer
goods in the future.

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Explanation:
• If the whole of the current capacity is used to produce only Consumer Goods and
no new Capital Goods are made, production of Consumer Goods in the future will
be affected, once the existing machineries reach their useful life.
• So, it is prudent to reduce present consumption to a certain extent, and direct that
portion towards Capital Formation, i.e. making Capital Goods.
• Thus, to assist Capital Formation, i.e. accumulating Capital Goods –

a) current consumption is to be sacrificed to a certain extent, and
b) current income should be saved.
Stages in Capital Formation process

• stage I Creation of Savings.
• Stage II Mobilization of Savings.
• Stage III Investment of Savings into Real Capital.
Entrepreneur
Meaning:
Entrepreneur is the person who combines the various factors of production in the
right proportions, initiates the process of production and bears the risk involved in it.
Features of Entrepreneurship:
a) Entrepreneur is also called as the Organizer, Manager or the Risk-taker. But
Entrepreneurship is a wider term than Organization and Management of a
business.
b) Without the Entrepreneur, the other factors of production would remain
unutilized or idle. Hence, he is the catalyst in the process of using the factors of
production.
c) Entrepreneur holds the final responsibility of the business.

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d) Enterprise function gives direction to the usage of other factors of production.

Land, Labour and Capital, by themselves, will not lead to production activity.
e) Entrepreneurship gets its reward (i.e. Profit), only after all other factors of
production have been rewarded, i.e. after Rent, Wages and Interest.
Functions of an Entrepreneur
Initiating and running the business:
• The Entrepreneur has to collect the other factors of production (Land,
Labour,Capital) and bring co-ordination among them.
• He has to pay the fixed contractual remuneration to the other factors of production
- (i) Rent for Land, (ii) Wages for Labour, and (iii) Interest towards Capital.
• Surplus, if any, after meeting all Fixed Costs and Variable Costs, accrues to the
Entrepreneur as his reward for his efforts and risk-taking.
• Reward for an Entrepreneur (i.e. Profit) is not fixed. He may earn profits, or
sometimes incur losses:
• Other Factors of Production get their payment at a fixed rate / amount,
irrespective of whether the Entrepreneur makes profits or losses.
Risk-Bearing:
• The final responsibility for the success and survival of business lies with the
Entrepreneur.
• In a dynamic economy, there are constant changes in - (i) demand for a
commodity, (ii) cost structure, (iii) tastes and fashions of consumers, (iv)
Government's industrial, taxation and economic policies, (v) credit availability
and rate of interest, etc.
• What is planned and anticipated by the Entrepreneur may not come true, and the
actual course of events may differ from what was anticipated and planned. In case
of adverse changes, there may be losses for the Firm.

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• The Entrepreneur has to assess and bear different risks, viz. Financial Risks,
Technological Risks, etc. These risks cannot be insured, and are also called
Uncertainties.
• The role of the Entrepreneur is to manage all these uncertainties and risks, and
yet earn profits.
Innovations:
• The Entrepreneur is to introduce and bring about innovations, on a continuous
basis. .
• Innovations may consist of the following –
a) Introduction of a new or improved product,
b) Introduction of new or improved production methods / machinery,
c) Utilisation of new or improved source of Raw Material,
d) Opening-up new or improved markets,
e) Adoption of new or improved forms of organisation, etc.
• Since the Entrepreneur seeks to maximize profit, he will innovate so as to find

better products, methods of production etc. to overcome the effects of
competition, and emerge as a leader.
Enterprise’s Objectives
Organic Objectives:
These comprise –
• Survival,
• Growth and Expansion, explained as under –
Aspect Description
• to survive or to stay alive,

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• to produce and distribute products or services at

Survival - i.e. the a price which enables it to recover its costs,
objective of a Firm - • to recover its costs of staying in business,
• to meet its obligations to its Creditors, Suppliers
and Employees,
• to avoid bankruptcy or insolvency,
• to ensure the continuance of its business activity,
• to provide the basis for growth, i.e. only if a Firm
is assured of its survival, it can aim at growth and
expansion.
1. Growth as an objective has assumed importance

with the rise of Professional Managers, and the
structural division of ownership and
management in Corporate Firms.
Growth and Expansion
2. The goal that Managers of a Corporate Firm set
(R.L.Marris'Theory)
for themselves is to maximise the Firm's
balanced growth rate subject to managerial and
financial constraints.
3. The ability or success of Managers is judged by
their performance.
4. Owners want to maximise their Utility Function
which relate to Profit, Capital, Market Share and
Public Reputation. Managers want to maximise
their Utility Function which includes variables
like Salary, Power, Status and Job Security.
5. There may be divergence and some conflict
between these Utility Functions. However, most
of the variables incorporated in both of them are
positively related to size of the Firm. So, the two

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Utility Functions converge into a single variable,

namely, a steady growth in the size of the Firm.
6. Thus, Managers do not aim at optimizing profits,
rather they aim at optimization of the balanced"
rate of growth of the Firm (as measured by rate
of increase of demand for the commodities of the
Firm and the rate of increase of capital supply).
Economic Objectives:
These relate to the Profit Maximizing Objective and Behaviour of Business Firms,
which forms one of the basic assumptions of Micro Economic Theory.
Aspect Description
a) Under the Profit Maximisation assumption /

objective / behaviour, the Firm determines the
Rationale for Profit
price and output policy in a manner so as to
Maximisation
maximize profits within the constraints imposed
Objective upon it such as technology, finance, etc.
b) This assumption / objective / behaviour is simple,
rational and quantitative and is amenable to
equilibrium analysis.
c) All Stakeholders expect an Enterprise / Company

to maximize profits –
• Investors expect that their Company will
earn sufficient profits in order to ensure fair
dividends to them and to improve the prices
of their Stocks.
• Loan Creditors, Banks and Financial
Institutions will be reluctant to lend money
to an Enterprise which is not making
profits.

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• Employees are interested in a profitable

enterprise, since continuity of employment,
increase in Salaries, Wages and Perquisite
of Employees, etc. can come only out of
profits.
• Government expects more tax revenues
from Profit-making Enterprises.
• Society at large expects an Enterprise to
utilize the scarce resources effectively &
earn profits.
Profit Maximisation Objective has been subject to

severe criticism in recent years. Some other views in
Modification of Profit this regard are
Maximisation • Satisficing: H A Simon argues that Firms have
Objective 'satisficing' behaviour and strive for profits that
are satisfactory.
• Sales Maximisation: Baumol's Theory holds that
Sales Revenue Maximisation rather than Profit
Maximisation is the ultimate goal of the Business
Firms. However, in their attempt to maximise
sales, Businessmen do not completely ignore costs
incurred on output and profits to be made.
• Security: Many economists have pointed out that
all Firms do not aim to maximise profits. Some
Firms try to achieve security, subject to reasonable
level of profits.
• Multiple Goals: Cyert and March suggests four
possible functional goals in addition to Profit Goal
namely, Production Goal, Inventory Goal, Sales
Goal and Market Share Goal.

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• Managerial Objectives: A. A. Berle and G.C. Means

pointed out that in large business corporations,
Management is separated from ownership, and so,
the Managers enjoy discretionary powers to set
goals of the Firm they manage.
• Managerial Utility: Williamson's Model seeks to
project that Owners (Shareholders) of Companies
prefer Profit Maximisation, but Managers
maximise their own utility function subject to a
minimum profit, rather than maximizing profit.
Note: The objective of Utility Maximization is
considered in the context of two types of Firms:
a) For Firms owned and managed by the
Entrepreneur himself, Utility Maximisation
implies that in choosing an output level,
Social Objectives:
An Enterprise lives in a society, and can grow only if it meets the needs of the Society.
Some of the major Social Objectives of Business would include –
a) To avoid profiteering and anti-social practices,
b) To create opportunities for gainful employment for the people in the society,
Human Objectives:
Human Beings are the most precious resources of an organisation. Some of the major
Human Objectives of Business would include –
a) To ensure comprehensive development of its Human Resources or Employees',
b) To provide fair deal and treatment to the employees at different levels,
c) To provide the Employees an opportunity to participate in decision-making in
matters affecting them,

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National Objectives:
An Enterprise should work towards fulfillment of national needs and aspirations and
work towards implementation of National Plans and Policies. Some of the National
Objectives of Business would include –
a) To produce goods and services, according to national priorities,
b) To remove inequality of opportunities and provide fair opportunity to all to
work and to progress,
Constraints in achieving the Objectives

In the pursuit of its Objectives, an Enterprise's actions may get constrained by many
factors. Some factors include –
Constraint Description
a) Business Enterprises operate in an uncertain world with

lack of accurate information.
Information
b) Many variables that affect the Firm's performance cannot
be correctly predicted for short/long runs.
c) It is very difficult to determine what the profit maximizing
Price is, and what level of output is optimum.
a) There may be infrastructural inadequacies and Supply

Chain bottlenecks resulting in shortages and unanticipated
Infrastructure
emergencies.
b) Examples: Issues like frequent power cuts, irregular
supply of Raw-Materials or Nonavailability of proper
transport, impact the ability of Enterprises to maximise
profits.
a) There may be constraints imposed by the Government on

the production, price and movement of factors. Also, there

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are practical hindrances for free mobility of Labour and

Factors of Capital.
Production
b) Firms may not be able to find skilled workforce at
competitive wages, or may have recurring need for
personnel training. There may also be restrictions as to
availability of Capital.
c) Example: Trade Unions may place several restrictions on
the mobility of labour or specialized training may be
required to enable workers to change occupation. Such
constraints may make attainment of maximum profits a
difficult task.
a) Aspects such as Inflation, rising Interest Rates, unfavorable

Exchange Rate fluctuations cause increased Raw Material,
Economic Capital and Labour Costs and affect the budgets and
Aspects financial plans of Firms.
b) Events like Demonetization may have an impact on the
operational activities of Firms in the short run.
THE PRODUCTION FUNCTION
• Production Function is the functional relationship between physical inputs (i.e.

factors of production), and physical outputs (i.e. quantity of goods / services
produced).
• Production Function states the relationship between inputs and output, i.e. the
maximum amount of output that can be produced with given quantities of inputs,
in the existing state of technology.
• Production Function gives the minimum quantities of various inputs that are
required to yield a given quantity of output.

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Cobb-Douglas Production Function
• Paul H. Douglas and C.W. Cobb of U.S.A studied production function of

American Manufacturing Industries.
• This production function applies not to an Individual Firm but to the whole of
Manufacturing in the United Status.
• In this case, Output is manufacturing production and inputs used are Labour
and Capital.
• Cobb-Douglas Production Function is Q=K LaC (1-a) where Q is output, Lis

Quantity of Labour and C the quantity of Capital. K and a are Positive Constants.
• This statistical study reveals Labour contributed about 3/4th and Capital about
l/4thof the increase in the Manufacturing Production.
Short Run and Long Run Production Function
Time Period Short-Period or Short-Run Long - Period or Long-Run
It is the period of time which is It is the period of time in which

too short for a Firm to install all the factors of production are
New Machineries / Capital variable. So, the Firm will be
Meaning
Equipment’s to increase able to install new machineries /
production. Equipment’s, apart from
increasing the units of Labour,
Materials, etc.
Only one Factor of Production There is no Fixed Factor of

Fixed Factor is kept constant or fixed. Production in the long-run
[Generally, Land, Capital or planning horizon.
Enterprise is taken as fixed.]

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Variable All Factors of Production other All Factors of Production are

Factor than the Fixed Factor (i.e. variable.
Labour, Raw Materials, etc.)
are considered variable.
Proportion Proportion between factors Quantity of Factors changes, i.e.

between changes, i.e. more use of the More use of the all Factors,
Factors Variable Factor, keeping Fixed keeping the proportion as
Factor as constant. constant.
Theory Law of Variable Proportions is Law of Returns to Scale is

applicable in the short-run. applicable in the long-run.
Terms Involved
• Total Product is the total output resulting from the

efforts of all the factors of production, combined
Total Product
together at any time.
• If the inputs of all but one factor are held constant,

then Total Product will vary with the quantity used
of the Variable Factor.
Example: For a machine with a specified production

capacity, Total Output will increase as additional
quantities of Raw Materials are used for processing.
Average Product • Average Product is the Total Product per unit of the
Variable Factor.

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• So, Average Product = Total Product -f Quantity of the

Variable Factor. –
Marginal Product a) Marginal Product is the change in Total Product, for one
unit change in the quantity of Variable Factor.
b) Marginal Product is the addition made to Total Product,
by an additional unit of input (of the Variable Factor).
Example: Total Product Schedule In the following example, Labour (number of

workers) is considered as the Variable Factor.
Relationship between Average Product and Marginal Product

Average Product (AP) and Marginal Product (MP) are derived (i.e. calculated) from
the Total Product. The relationship between AP and MP is given below -
MP Curve rises steeply and is higher than AP,

when AP increases.
• When AP is maximum, MP = AP.

When AP is maximum, MP = AP. • MP declines slightly earlier than AP.
So, the MP curve cuts the AP
• MP Curve cuts AP Curve, when AP is
Curve at its maximum.
maximum.
• MP Curve cuts AP Curve only from above,

and not from below.
• When AP decreases, MP < AP.

When AP decreases due to
• MP Curve declines steeply than AP.
increased use of the variable
input factor, MP is less than AP.

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• MP may become zero and negative later, but

AP continues to remain positive (i.e. not zero
or -ve).
Note: The above relationship is based on the Law of Variable Proportions [Refer Para
C.1], in the same sequence of stages as stated in that law, i.e. First Increasing, then
Diminishing and then Negative Returns.
Relationship between Total Product and Marginal Product
• When TP increases at an increasing rate, MP shows an increase.
• When TP increases at a decreasing rate, MP shows a decrease.
• When TP is maximum, MP is zero.
• When TP decreases, MP becomes negative.

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Note: The point on the TP Curve when MP is maximum, is called Point of

Inflexion.

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THE LAW OF VARIABLE PROPORTIONS
Law of Variable Proportions
• The Law of Variable Proportions analyses the production function with one factor
as variable, keeping quantities of other factors fixed.
• So, the Law refers to input—output relationship, when the output is increased by
varying the quantity of one input.
• This Law operates only in the short-run, i.e. When all factors of production cannot
be increased or decreased simultaneously.
• This Law is also called –

1. Law of Proportionality,
2. Law of Diminishing Returns,
3. Law of Diminishing Marginal Physical Productivity.
Assumptions of the Law
1) The state of technology is constant and unchanged.
2) Only physical quantities of inputs and outputs are considered. Economic

profitability of the Firm is not considered in monetary terms.
3) Only one factor input is considered variable, while all other factors of production
are considered fixed. It assumes that there must be some inputs whose quantity is
kept fixed. [Example: In agriculture, the land area is taken as constant, while
number of workers can be increased.]
4) Factors of Production can be used in any proportion, i.e. there is no fixed

proportion of factors. If all factors are required to be used in fixed proportions,
then an increase in one factor would not lead to any increase in output at all.

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5) The Fixed Factor of production is scarce, i.e. available only a certain extent. Its
availability cannot be increased in the short-run, and there are no perfect
substitutes for such Fixed Factor. [Example: Land area under cultivation is
constant, and there is no perfect substitute for land.]
Behaviour of TP, AP and MP
1) Law of Variable Proportions:
• As the quantity of one input which is combined with other fixed inputs is
increased, the Marginal Physical Productivity of the Variable Input must
eventually decline.
• At the given state of technology, an increase in some inputs relative to other

fixed inputs, will cause output to increase initially. But after a point, the
extra output resulting from the same addition of extra inputs will become
less endless.
2) Behaviour of TP, MP and AP: Refer to the diagram given in Para

As per the Law of Variable Proportions, the behaviour of TP, MP and AP can be
analyzed in three stages as under –

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Increasing Returns
The Law of Increasing Returns operates due to the following reasons –
Reason Explanation
• Initially, the quantity of Fixed Factors is

abundant (and also unutilized), in relation to
the quantity of the Variable Factor.
Full Use of Fixed
• As more units of Variable Factors are added to
Indivisible Factors
the constant quantity of the fixed factors, the
Fixed Factors are more intensively and
effectively utilized. This causes the production
to increase at a rapid rate.
• So, the efficiency of the Fixed Factors
increases, as additional units of the Variable
Factors are added to it.
• Example: If a Machine can be efficiently
operated when 5 persons are working on it,
and if initially the machine is operated with
only 3 persons, production increases till the
point 5thperson is employed, since the
machine will be effectively utilised to its
optimum.
• As more units of the Variable Factors are put

to use, the efficiency of the Variable Factors
Efficiency of Variable itself increases.
Factors
• This arises due to two simple facts - (i) What
one man cannot do, two can do, and (ii) What
one man can do, two can do better.

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• This is attributed to reasons like specialization

of functions, division of labour, use of
standardized tools and processes, etc. This
results in higher productivity.
• Returns may diminish only when Variable

No Scarcity of Variable Factors are affected by scarcity, e.g. additional
Factors workers are not available.
• However, when Variable Factors are not

scarce, output tends to increase.
• Production Efficiency (i.e. increased output) is

Reaching the right possible, till the right combination between
combination Fixed Factors and Variable Factors is achieved.
• Based on the example in Point 1 above, the
output will continue to increase, till the 5th
person is employed.
Law of Diminishing Returns
Note: Stage II is called Law of Diminishing Returns since MP and AP both show
decreasing trend. However, both MP and AP remain positive.
The Law; of Diminishing Returns operates due to the following reasons -
Reason Explanation
• Once the point of right combination is

Inadequacy of reached (i.e. efficient utilisation of Fixed
Fixed Factor Factor), further increase in the Variable
Factor will cause MP and AP to decline.
This is because the Fixed Factor then

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becomes inadequate, in relation to the

quantity of the Variable Factor.
• Example: Based on the Machine example

given above, putting the 6th person on
the same machine, makes the
contribution of the latter Nil, So, Average
Output, (as well as Marginal Output) will
decline.
• Once the Fixed Factor has reached its

Less efficiency of maximum capacity, there is no further
Variable Factor scope'/' possibility of efficiency of the
Variable Factor.
• Average Efficiency of the Variable Factors

can increase only if the Fixed Factors
supports such extra output. Average
Product of the Variable Factor
diminishes, when the Fixed Indivisible
Factor is being worked too hard.
• It is assumed that there is no perfect

Imperfect Substitutes substitute for the scarce Fixed Factor.
• If such perfect substitutes were available,

then the shortage of the scarce Fixed
Factor can be made up by using its
perfect substitute, such that output could
be increased.
Wrong combinations • Any deviation from the right or optimum

combination will result in lower
productivity of the factors of production.

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• Using more and more of the Variable

Factor disturbs the optimum
combination, and reduces output /
productivity.
Law of Negative Marginal Returns
• The Law of Negative Returns operates when the quantity of

Variable Factor becomes too excessive, in relation to the Fixed
Reason Factor, so that they get in each other's ways. Due to this, the
total output falls instead of rising.
• In such a situation, only a reduction in the units of the Variable

Factor will increase the total output.
Based on the Machine example given above, putting the 6 th or 7

Example
th person on the same machine becomes a nuisance and causes
obstruction to the other workers. This will reduce the Total
Output.
THE LAW OF RETURNS TO SCALE
Meaning:
Change in Scale means that all Factors of Production are increased or decreased in
the same proportion. The Law of Returns to Scale analyses the changes in output, due
to changes in scale in the long- run, i.e. quantities of resources, keeping proportion
constant.
Law of Returns to Scale:

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When there is an increase in scale (i.e. increase in all factors of production together
in the same ratio), the Marginal Product –
1. increases at first,
2. becomes constant thereafter, and
3. starts decreasing beyond a certain level.
Example:
Assume basic proportion of resources is 1 machine and 3 workers, i.e. 1 M + 3 W.
Here, TP and MP are indicated in quantity (units).
• The Production Function for the economy as a whole generally exhibits constant
returns to scale.
• An Individual Firm passes through a long phase of constant returns to scale in its
lifetime.
• It is otherwise called as Linear Homogeneous Production Function

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COST AND REVENUE CONCEPT
Cost Function
• Meaning:
Cost Function refers to the mathematical relationship between cost of a product
and the various determinants of cost.
• Variables:
The following are the dependent and independent variables in a Cost Function -
Dependent Variable Independent Variable can be -
Total Cost or Size / Quantity of Output,

Unit Cost, i.e. Cost per unit of Output Scale of Operations,
Price of Factors of Production,
Other relevant phenomenon having a

bearing on cost, e.g. Technology, Level of
capacity utilisation, Efficiency, Time Period
under study, etc.
Cost Classifications
Explicit Costs vs Implicit Costs
Particulars Explicit Costs Implicit Costs

Meaning
Costs which involve payment Costs which do not
made by the Entrepreneur to involve any cash payment

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providers of other factors of to outsiders are called

production, i.e. Land, Labour Implicit Costs. It is the
and Capital. monetary reward for all
factors owned by the
Entrepreneur himself, and
employed by him in his
own business,
Out-of-Pocket Costs / Outlay Notional / Imputed /

Also known as
Costs. Opportunity Costs.
These are actually incurred and They are not actually

Measurement
hence can be easily and incurred. They cannot be
objectively measured. easily measured and
involve subjective
estimation.
Recorded in books of accounts. Not recorded in books of

Recording
account.
Accounting, Reporting, Cost Decision-Making

Purposes
Control & Decision Making. purposes.
Rent, Wages & Salaries, Interest Interest on own Capital,

Examples
on Loans borrowed for Rent of own premises,
business, etc. Salary to Entrepreneur,
etc.
Note:
Normal Profits

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If Revenues = Economic Costs (Explicit + Implicit Costs - Refer Para A.3.2), the
Entrepreneur is said to be earning Normal Profits.
Abnormal Profits
If Revenues > Economic Costs, the Entrepreneur is said to be earning Abnormal
Profits.
Accounting Costs and Economic Costs
Accounting Costs = Explicit Costs.

Economic Costs = Explicit Costs + Implicit Costs.
Land owned by Entrepreneur and used for business

purposes, on which no Rent is paid.
Wages or Salary not paid to the Entrepreneur, but

Implicit Cost
could have been earned if his services had been sold
somewhere else, i.e. if he were employed in another
Firm.
Normal Return on Money Capital invested by

Entrepreneur himself in his own business.
Comparison of Explicit and Implicit Costs in different situations
Factors of Production The reward is Explicit The reward is Implicit

Cost if – Cost if -
Land

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Rent is paid to the Land is owned by the

Landlord separately. Entrepreneur.
Salary / Wages paid to Own people (e.g. family

Labour Employees / Workers. members) are employed
in the Firm, without
paying them any reward
for their work.
Capital is borrowed and Entrepreneur employs his

Capital
used in the business. own funds as Capital.
Entrepreneur Not Applicable Entrepreneur himself

manages the business.
Opportunity Costs
• Opportunity Cost refers to the value of sacrifice made, or benefit of opportunity

foregone in accepting an alternative course of action.
• Opportunity Cost refers to the cost of opportunity foregone, and it involves a

comparison between the policy that was chosen and the policy that was
rejected, Costs relating to sacrificed alternatives.
• Opportunity Cost arises only when alternatives are available. If a resource can
be put only to a particular use, there are no Opportunity Costs.
• Opportunity Costs do not involve any cash payment as such. Thus, they are
different from Outlay Costs, which involve some payment to outsiders.
• Opportunity Cost is not recorded in books of accounts. It is considered only for

decision- making and analytical purposes.
• Examples:

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a) A Firm may finance its expansion plan by withdrawing money from its
Bank Deposits. Here, the loss of interest on the Bank Deposit is the
Opportunity Cost for carrying out the expansion plan.
b) A person quits his job and enters into business. Here, the Salary foregone
from employment constitutes Opportunity Cost.
Direct Costs vs Indirect Costs
Basis Direct or Traceable Costs Indirect or Non-

Traceable Costs
Nature Direct Costs are costs that are Indirect Costs are not
readily identified and are readily identified nor
traceable to a particular visibly traceable to specific
product, service, operation or goods, services, operations,
plant. etc.
Cost of Raw Material used in Factory Rent, Electric

Example
manufacture, Wages paid to Power, and other Common
Workers in a construction Costs incurred for general
contract, etc. operation of business
benefiting all products
jointly.
They can be generally Though not quantifiable,

Relationship
quantified and expressed per they may bear some
unit of output, e.g. 5 kg of Raw functional relationship to
Materials per unit of product, production, may vary with
etc. the volume of output in
some definite way.

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They are directly charged to the They are apportioned or

Accounting product, operation or plant as absorbed over different
they are directly identifiable. products, or departments,
using appropriate basis.
Fixed Costs vs Variable Costs
Fixed Costs
• Fixed Costs are costs that do not vary with output, upto a certain level of
activity.
• They are period related. They are taken as a function of time and not of
output.
• They are incurred even at zero level of output, i.e. even before output is
produced.
• Some portion of Fixed Costs cannot be avoided even when operations are
suspended.
• Fixed Cost per unit of output decreases with increase in output, and vice -
versa, upto certain level of output.
• Rent, Insurance, Interest on Loans, Depreciation, etc. are Fixed Costs.
Variable Costs
• Variable Costs are costs that vary, based on the level of output.
• They are product-related. They are taken as a function of output and not of
time.
• They are incurred only when production commences.

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• Variable Costs are avoidable costs, as it is incurred only when production takes
place.
• Variable Cost per unit of output generally remains constant, if Total Variable
Costs vary proportionately with output.
• Cost of Raw Materials and Wages are Variable Costs.
Committed Fixed Costs vs Discretionary Fixed Costs
Committed Fixed Costs

• These are Fixed Costs that arise from the possession of –
a) Plant, Building and Equipment (e.g. Depreciation, Rent, Taxes, Insurance

Premium etc.), or
b) A basic organisation (e.g. Salaries of Staff).

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• These costs remain unaffected by any short-term changes in volume of

production.
• Any reduction in Committed Fixed Costs under normal activities of the Firm
would have adverse effects on the Firm's long-term objectives.
• These costs cannot be controlled.
• Also known as "Unavoidable" Fixed Costs.
Discretionary Fixed Costs

• These are Fixed Costs incurred as a result of management's discretion.
1. It arises from periodic (usually yearly) decisions regarding the

maximum outlay to be incurred; and
2. It is not fixed to a clear cause and effect relationship between inputs and
outputs.
• These cannot be changed in the very short-run.
• Discretionary Fixed Costs can change from year to year, without disturbing the
long-term objectives of the Firm.
• These costs can be controlled.
• Also known as "Avoidable" Fixed Costs.
Marginal Cost
1. Meaning:
Marginal Cost is the addition made to the total cost by production of an
additional unit of output.

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2. Impact of Fixed & Variable Costs:

Marginal Cost is independent of Fixed Cost. Since Fixed Costs do not change
with output, only Variable Costs and output quantity will have an influence on
Marginal Costs.
3. Marginal Costs per unit =

Difference in Total Cost (TC) between two output levels Difference in Output
Quantity at those levels
4. Note:
In the above formula, instead of Total Cost, Variable Cost can also be taken,
since Fixed Cost does not change over various levels of output.
5. Behaviour of Marginal Cost Curve:

a) The behaviour of MC Curve is the reverse of the behaviour of the
Marginal Product (MP) Curve under the Law of Variable Proportions.
b) Marginal Product (MP) Curve rises first, reaches a maximum and then
declines, as seen in the Law of Variable Proportions. (Refer Chapter 5)

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c) So, Marginal Cost (MC) Curve of a Firm declines first, reaches its
minimum and then rises. Hence, Marginal Cost Curve of a Firm is U-
shaped.
Note: The following abbreviations are used In this Chapter:
TR = Total Revenue AC = Average Total Cost
AR = Average Revenue AVC = Average Variable Cost
MR = Marginal Revenue AFC = Average Fixed Cost
TC = Total Cost SAC = Short-Run Average Cost
TVC = Total Variable Cost SMC= Short-Run Marginal Cost
TFC = Total Fixed Cost LAC = Long-Run Average Cost
LMC= Long-Run Marginal Cost
Other Cost Concepts
Incremental Costs vs Sunk Costs:

Incremental Costs:
• Incremental Cost refers to the additional cost incurred by a Firm as result of a
business decision.
• Incremental Costs will have to be incurred by a Firm when it makes a decision

to change its product line, replace worn out assets, buy a new production
facility or acquire new Clientele, etc.
• Incremental Costs are relevant for business decision-making.
Sunk Costs:

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• Sunk Costs refer to those costs which are already incurred once and for all, and
cannot be recovered.
• Sunk Costs are based on past commitments and cannot be altered or revised or
reversed, if the Firm wishes to do so, e.g. R&D, Advertising, etc.
• Sunk Costs act as an important barrier to entry of Firms into business.
Historical Costs vs Replacement Costs:

Historical Costs
• Historical Cost, refers to the cost incurred in the past, on the acquisition of a
productive asset like Machinery, Building, etc.
• Since they are already incurred in the past, they are not useful for current or
future decisions.
Replacement Costs
• Replacement Cost is the money expenditure that has to be incurred for

replacing an old asset.
• It is the cost of replacement of an Asset or Resource at the current market price,
and is useful for decision-making.
Note: Generally, an increase in price will make Replacement Costs higher than
Historical Cost.
Private Costs vs Social Costs:

Private Costs
• Private Cost refers to the Cost of Production incurred and provided for by an
Individual Firm engaged in the production of a commodity.
• Private Costs are borne by the Individual Firm.

• Private Cost= Explicit & Implicit Costs incurred by the Firm.

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• It is found out to get Private Profits.
• Examples: Cost of Factors of Production
Social Costs
• Social Cost refers to the cost of producing a commodity to the society as a
whole. It takes into consideration all those costs, which are borne by the society
directly or indirectly.
• Social Cost is not borne by the Firm. It is rather passed on to persons not
involved in the activity in the direct way.
• Social Cost=Private Cost+ External Cost (i.e. Externalities).
• It is found out to get Social Profits rather than Private Profits.
• Examples: Cost of Resources which a Firm is not required to pay for, e.g. Rivers,
Roadways, etc. + Cost of disutility created by a Firm, e.g. air, water pollution,
etc.
SHORT-RUN AND LONG-RUNCOST BEHAVIOUR
Total Costs - Short-run

In the short run, the following Total Cost Concepts arise –
• Total Variable Cost (TVC),

• Total Fixed Cost (TFC), (GRAPH)
• Total Cost (TC).
Note: In addition to the above, Marginal Costs may also be analyzed and depicted. The
behaviour of the above Total Cost Curves is given as under -
Item Nature

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TFC Curve Horizontal Straight Line, i.e. parallel to X-axis.
Curve with positive slope, i.e. upward to the right, and lower than
TVC Curve TC Curve.
TC Curve Curve with positive slope, i.e. upward to the right, and higher than
TVC Curve.
In the short run, the following Average Cost Concepts arise –

a) Average Variable Costs (AVC) = TVC ÷Q (GRAPH)
b) Average Fixed Costs (AFC) = TFC ÷ Q
c) Average Total Costs (ATC) = TC ÷ Q
Note:
• Q = Number of Units of output.
• Average Total Costs are merely referred to as Average Costs (AC).
• In addition to the above, Marginal Costs per unit are also analyzed and
depicted.
Note:
The diagram given here depicts the general behaviour of each Cost Curve. It is not
drawn as per the data given in the Table in the previous page.
Behaviour of Average Costs and Average Cost Curves in Short-run
Item Behaviour of Cost Behaviour of Curve
AFC • AFC = TFC ÷Q. • AFC Curve is negatively

sloped, i.e. slopes

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• TFC remains constant downwards from left to

irrespective of increase in Q. the right.
• So, AFC is inversely related to Q, • AFC Curve will not touch

i.e. as Output (Q) increases, AFC the axis since AFC
decreases, and vice-versa. [See cannot be = 0.
Column E above for decrease
from 75 to 1.50]
AVC • AVC = TVC ÷ Q. • AVC Curve will fall first,

for the output level upto
• Upto normal capacity output,
normal capacity.
AVC decreases as output
increases, due to initial • AVC Curve will reach a
increasing returns. minimum, and then rise
again.
• Beyond normal capacity output,
AVC will rise steeply, due to the • AVC is not exactly a U-
operation of diminishing returns. Shaped Curve.
• See Column F above for decrease
from 10.00to 7.50, and thereafter
further increase to 15.00.
• AC = TC ÷ Q (or) AC = AFC + AVC. • AC Curve will fall, first,

AC OR ATC due to sharp decline in
• In the initial stages, AC will AFC.
decline sharply due to fall in AFC.
• AC Curve will reach a
• Even when AVC rises, AC minimum, and then rise
continues to decrease since the again, due to increase in
fall in AFC is greater than the rise AVC.
in AVC.
• AC is a U-Shaped Curve.
• As output increases further, AC
starts increasing, since the sharp

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rise in AVC is more than fall in

AFC.
• See Column G above for decrease

from 85.00 to 15.00, and
thereafter further increase to
16.50.
• Marginal Costs p.u. = Diff. in TC ÷ • MC Curve will fall first,

Diff. in Q. reach a minimum, and
then rise again.
MC • MC declines initially, reaches a
minimum, and thereafter • MC is a U-Shaped Curve.
increases.
• MC cuts AC from below,
• See Column H above for decrease when AC is minimum.
from 10.00 to 6.00, and
thereafter further increase to
17.00.

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Relationship between Average Cost and Marginal Cost Curves
The relationship between AC and MC is given below
Rule Relationship between AC and Point to Remember

MC
1. When AC falls as a result of an
increase in output, MC is less than • When AC falls, MC < AC.
AC.
• MC Curve is lower than
AC, when AC decreases.
2.
When AC is minimum, MC = AC. So, • When AC is minimum,
the MC Curve cuts the AC Curve at MC = AC.
its minimum. • MC increases slightly
earlier than AC.
• MC Curve cuts AC
Curve, when AC is
minimum.
• MC Curve cuts AC Curve

only from below, and
not from above.
3.
When AC increases due to increase • When AC decreases, MC
in output, MC is greater than AC. > AC.
• MC Curve rises steeply

than AC.
Note: The relationship between AC and MC is the reverse of the relationship between
AP and MP.

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The Long-Run Average Cost Curve
• LAC Curve:
A Long Run Average Cost Curve (denoted as LAC Curve) depicts the functional
relationship between output and the long-run cost of production.
• No distinction of Fixed-Variable:
All factors of production are variable in long-run, andhence every cost is
variable. The distinction between Fixed and Variable Costs does not arise in the
long-run.
• LAC = Least Cost:
a) In the long-run, the cost of production is the least for any given level of
output, as all individual factors are variable. So, a Firm can move from
one Plant to another, acquire a bigger Plant if it wants to increase its
output, and a small plant if it wants to reduce its output.

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b) The shift will be to ensure the least cost for that level of output, in the
long-run.
c) Hence, AC cannot be higher in the long-run, than in the short-run. Thus,

LAC is the least-cost combination, for any particular output level.
• Planning Curve:
LAC Curve is called Planning Curve, since the Firm plans to produce any output
in the long-run by choosing a Plant on the LAC Curve corresponding to the
given output. Thus, LAC Curve helps the Firm in the choice of the size of the
plant for producing a specific output at the least possible cost. Note: SAC
(Short-Term Average Cost) Curves are called Plant Curves, and LAC (Long Run
Average Cost) Curve is called Planning Curve.
Note: SAC (Short-Term Average Cost) Curves are called Plant Curves, and LAC (Long
Run Average Cost) Curve is called Planning Curve.

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Derivation of the LAC from the SAC
LAC derived from SAC:

LAC Curve is derived as an envelope / tangent of all SAC Curves. Further, the LAC
Curve is a U- Shaped Curve, due to the operation of Law of Returns to Scale. The
determination of LAC Curve from the various SAC Curves is explained below
• Selecting the suitable SAC Curve at different output levels:
a) In the long-run, for any output level, the Firm will examine and decide
which size of plants it should operate, so as to minimize its Cost (i.e. AC).
The Firm will decide on which SAC Curve it should operate to produce a
given output, so that its AC is minimum.
b) From the diagram given here, the following can be inferred - In the long-
run, the Firm has a choice in the use of Plant and it will use that Plant
which has Minimum SAC for producing a given output.
In the long-run, the Firm has a choice in the use of Plant and it will use that Plant
which has Minimum SAC for producing a given output.

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Output SAC Preferred
Ox SAC: (since B lying on SAC1 is lower than A lying on SAC2)
02 SAC2 (since D lying on SAC2 is lower than C lying on SAC1)
03 SAC3 (since F lying on SAC3 is lower than E lying on SAC3)
>03 SAC3 (since every point on SAC3 is now lower than SAC2)
Note: [The Firm should select the SAC, not the lowest point of that SAC.]
• The points of operation, i.e. B, D, F and G need not be the minimum points of
the respective SACs. However, it should be the SAC on which the lowest cost is
obtained for that level of output
• So, the Firm will choose the appropriate lowest cost SAC for an output level,
and not the lowest point on that SAC.
• The Smooth Curve connecting points B, D and G, constitutes the LAC Curve for
the Firm.
Deriving LAC Curve in case of numerous / infinite SAC Curves:

a) If the Firm has choice between infinite number of plants (with infinite SAC
Curves), the LAC Curve will be a smooth curve enveloping all these SAC Curves.
b) In the diagram, the LAC Curve is drawn as a smooth curve, so as tobe tangent to
each of the SAC Curves.
c) If a Firm desires to produce any particular output level, it will build a

corresponding Plant and operate on that Plant's SAC Curve.
d) Higher levels of output can be produced at the lowest cost, with a larger plant,
and vice-versa.
Note: LAC Curve is tangent to each of the SAC Curves, not the minimum points
of the SAC Curves. So

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When LAC Curve is - LAC will be tangent to - Principle
the falling portions of the Returns to Scale will first

declining
SAC Curves. increase, due to internal
and external economies.
So, LAC will decline.
Rising the rising portions of the Returns to Scale will

SAC Curves. decrease later, due to
internal and external
diseconomies. So, LAC will
rise.
Thus, as a result of initial fall and subsequent increase in LAC, it will be a U - shaped
Curve.
REVENUE CONCEPTS
Total, Average and Marginal Revenues
Item Explanation
(a) Total Revenue (TR) refers to the amount of money

which a Firm realizes by selling certain units of a
Total Revenue
commodity.
(T R)
(b) TR = P x Q, where P = Price, and Q = Quantity sold.
(c) Example: If a Firm sells 500 units of a product for ₹ 20

each, then its Total Revenue will be 500 units × ₹ 20 = ₹
10,000.
Average Revenue
(A R)

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• Average Revenue (AR) is the revenue earned per unit of

output.
• AR is the price of one unit of output, since Price is always

per unit of a commodity.
• AR = TR = P ×Q = P. Hence, AR = Price. Q Q
• Example: Total Revenue of a Firm is ₹ 50,000 by the sale

of 2,000 units. Hence, AR = ₹ 50,000 ÷ 2,000 = ₹ 25 p.u.
• Note: Since AR = Price, the AR Curve of the Producing

Firm is the same as the Demand Curve of the Consumer,
since Demand Curve specifies the quantity that the
Consumer will be buying (i.e. Producing Firm can sell) at
various prices.
• Marginal Revenue (MR) is the change in Total Revenue

(TR) resulting from the sale of an additional unit of the
Marginal revenue
commodity.
( MR)
• MR is the rate of change in Total Revenue resulting from
the sale of an additional unit.
• MR = ∆TR where Q is quantity of a commodity sold, A is

the rate of ∆Q change.
• For one unit change in output, MRn = TRn - TRn
where, TRn is the Total Revenue when sales are at the rate
of n units per period.
TRn-1 is the Total Revenue when sales are at the rate of n -
1 units per period.
Relationship between TR, AR, MR and Price Elasticity of Demand

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Relationship between Elasticity of Demand, AR and MR:
• Marginal Revenue (MR), Average Revenue (AR) and Price Elasticity of Demand
(e)are related to one another through the formula, MR = AR × e−1 q
• So, the following principles will apply - ("Students may remember that AR =
Demand Curve
MR Explanation

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If e < 1 MR will be negative. This will lie on the Lower

Segment of the AR /
Demand Curve.
This will be the Mid-Point

If e = 1 MR = 0.
of the Straight-Line AR
Curve. At the midpoint of
Straight-Line Demand
Curve, e = 1.
This will lie on the Upper

If e > 1 MR will be positive.
Segment of the AR /
Demand Curve. –

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Summary of Relationships
TR and MR • If TR increases, MR will be positive.

• When TR is maximum, MR = 0.
• If TR decreases, MR will be negative.
• MR and AR both decline, but MR falls rapidly than AR.

MR and AR • AR Curve is flatter than MR.
• MR can be zero and even negative, while AR will never
cross below the X axis.
• At the point where MR = 0, Elasticity of Demand on AR
Curve will be 1.
Equilibrium Point of the Firm

• It will be profitable for the Firm to expand its output whenever Marginal Revenue
(MR) is greater than Marginal Cost (MC), and to keep on increasing output until
MR = MC.
• If any unit of production adds more to Revenue than to Cost, production and sale
of that unit will increase profits. Similarly, if it adds more to Cost than to Revenue,
it will decrease profits.
• Profits will be maximum at the point where Additional Revenue (MR) from a unit
equals its Additional Cost (MC). So, MC = MR.
• Further, the MC Curve should cut the MR Curve from below (and not from above).
This is so because, upto this point MR > MC, hence there is an incentive for further
production. Beyond this point, MC > MR.

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• This position (i.e. where MC = MR, and MC cuts MR from below) is called
Equilibrium position for the Firm.
• Merely being in Equilibrium position does not mean that the Firm is making
profits. The actual position of profits can be known only on the basis of AR and AC
Curves.
Note: For achieving Equilibrium Position, the conditions to be satisfied are –

• MC = MR, and
• MC Curve should cut MR Curve from below, i.e.
• MC should have +ve slope.
Profit / Loss at the Equilibrium Point
• Equilibrium Position (i.e. the output level at which MC = MR and MC cuts MR from
below) refers to the optimum output level that the Firm should try to operate.
• Merely being in Equilibrium position does not mean that the Firm is making
Curves.
• In the calculation of Costs, a normal percentage of profits for the entrepreneurial

services are included in computation of Costs of Production (AC) (as Economic
Costs). So, the rules for interpretation of profit / loss are as under –
Situation Interpretation
The Firm makes super-normal profits, i.e. over and above

If AR > AC
normal profits.
If AR = AC The Firm makes normal profits, since AC includes normal

profits.

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The Firm makes losses, but it need not shut down in the short-
If AR< AC
run. (See Para C.5) Note: Here, Loss means Economic Loss, and
not Loss as per Books of Accounts.
If AR < AVC The Firm is not able to recover even its Variable Costs. So, it has
to shut-down.
Shut Down Point

• If Revenue > Cost, the Firm will earn Profits.
• A Firm should not produce the product at all, if Total Revenue from its product
does not equal or exceed its Total Variable Cost. Hence, the condition for
production is TR> TVC.
• The Firm has the option of not producing anything. If it does not produce the
product, it will have an Operating Loss equal to its Fixed Cost only.
• A Firm should produce, only if it will do better by producing than by not

producing. Hence, TR should be greater than TVC, otherwise it will increase the
Loss of the Firm.
• So, the shut-down point of the Firm will be the situation when AR < AVC.

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Chapter- 4
Price Determination in Different Markets
Elements of a Market
Meaning:
1. Market is a place where Buyers and Sellers meet and bargain over a commodity
for a price.
2. Market = All Buyers and Sellers of goods or services who influence the price.
Elements of a Market:
The elements of a Market are –
a) Buyers and Sellers,
b) a Commodity, Product or Service,
c) Bargaining for a Price,
d) Knowledge about market conditions, and
e) One Price for a Product or Service at a given time.

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Types of Market Structures
The Market Structures analyzed in Economics are –
• Perfect Competition: Many Sellers selling identical products to many Buyers.

• Monopoly: Single Seller producing differentiated products for many Buyers.
• Monopolistic Competition: Many Sellers offering differentiated products to
many Buyers.
• Oligopoly: A Few Sellers selling competing products to many Buyers.
Note: Some other Market Forms are:

✓ Duopoly: Duopoly is a market situation in which there are only two Firms in
the market. It is a sub-set of Oligopoly,
✓ Monopsony: Monopsony is a market characterized by a Single Buyer of a
product or service. It is mostly applicable to Factor Markets in which a Single
Firm is the only Buyer of a Factor.
✓ Oligopsony: Oligopsony is a market characterized by a small number of large

buyers. It is also mostly relevant to Factor Markets.
✓ Bilateral Monopoly: It is a market structure in which there is only a Single
Buyer and a Single Seller. Thus, it is a combination of Monopoly Market and a
Monopsony Market.
PERFECT COMPETITION
Features
The features of Perfect Competition are –
Aspect Explanation
a) There are a large number of Buyers & Sellers who

Large No. of Buyers
compete among themselves.
&Sellers

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b) No individual Buyer or Seller will be in a position to

influence the demand or supply in the market.
a) Homogeneous = Similar or Identical in nature.

Homogeneous Products
b) Goods produced by different firms are identical in
nature.
Free Entry / Exit Every Firm is free to enter the market or to go out of it,
at any point of time.
There is a perfect knowledge, on the part of Buyers and

Perfect Knowledge
Sellers, of –
a) the quantities of stock of goods in the market,
b) market conditions, and
c) the prices at which transactions of purchase and

sale are being entered into.
There are adequate facilities for the movement of

Transportation
goods from one center to another.
a) The commodity or the goods are dealt on at a

uniform price throughout the market at a given
point of time.
Uniform Market Price
b) All Firms individually are Price Takers. They have
to accept the price determined by the market forces
of Demand and Supply.
 Buyers have no preference as between different

Indifference / Lack of
Sellers (since product is homogeneous), and as
Preference
between different units of commodity offered for
sale.
 Sellers are indifferent as to whom they sell (since
price is uniform).

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Mobility of Factors of
There is perfect mobility of factors of production.
Production
Note: A Free or Pure Competition is said to exist when the first three conditions only
are satisfied.
Determination of the Demand Curve
 In Perfect Competition, no individual Buyer or Seller will be in a position to

influence the demand or supply in the market. The Market Price is uniform.
 All Firms individually are Price Takers. They have to accept the price determined
by the market forces of Demand and Supply.
 All output can be sold at the same price only. Price Elasticity of Demand is infinity.
 If any Seller tries to increase his price above the Market Price, (i.e. price charged
by Other Firms), he would lose his customers. Also, no Seller would try to sell his
product below the Market Price since there is no incentive for lowering the price
(by way of additional quantity sold).
 Hence, the Equilibrium Price determined by Market Demand and Supply forces,
constitutes the Demand Curve for the Firm. This Price is also the Average Revenue

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(AR) and Marginal Revenue (MR) for the Firm, since the price is uniform in the
market. So, in Perfect Competition, D = AR = MR = Price.
In the Market For the Firm
Short Run Price, Output and Profit Determination

Determination of Short Run Equilibrium
Note: For achieving Equilibrium, the conditions to be satisfied are –
• MC = MR, and
• MC Curve should cut MR Curve from below, i.e. MC should have positive slope.
In Perfect Competition, the short-run equilibrium of the Market and Firm is

represented below –

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1. For the Firm, the Equilibrium is OQ2 units of output at Price P, since it satisfies
both the conditions given above.
2. OQ1 units cannot be considered as Equilibrium position since the 2nd condition
(MC cutting MR from below) is not satisfied.
[Note: As output increases from OQ1to OQ2, MR > MC, and there is scope for
earning more profits. Only beyond OQ2, MC > MR, which should be avoided.]
3. Merely being in Equilibrium position does not mean that the Firm is making
Curves.
Super-Normal Profits at the Short Run Equilibrium position
1. In the diagram given here, the Firm obtains equilibrium position at OQ units and
Price OP.
2. At that level, AR > AC, and hence, the difference between AR and AC constitutes
super-normal profits, as depicted by the shaded area.
3. All Firms in the industry which have a similar cost behaviour as shown here, will
be earning super-normal profits.

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4. New Firms may be attracted by such super-normal profits and try to enter the
industry, but such entry cannot be achieved in the short-run. So, the existing Firms
will continue to earn these super-normal profits.
5. Though the Firm is in equilibrium graph (inspite of having super-normal profits),

the industry as a whole will not be in equilibrium, since new Firms will try to enter
the industry.
[Note: MC cuts AC, only when AC is minimum i.e. at the lowest point of AC.]
Note: For Super Normal Profits, AR > AC, at a point where MC = MR (MC cutting from
below).
Normal Profits at the Short Run Equilibrium position
• In the diagram given here, the Firm obtains equilibrium position at OQ units and
Price OP.
• At that level, AR = AC, and hence, the Firm will be earning only Normal Profits,
since normal profits are already included in the computation of AC.

CA FOUNDATION
• Theoretically, the Industry as a whole should also be in equilibrium in this stage

of Normal Profits, but such industry equilibrium can be achieved only in the long-
run.
• Note: For Normal Profits under Perfect Competition, AR = AC, at a point where MC
= MR (MC cutting from below).
• So, AR = MR = MC = AC.
Losses at the Short Run Equilibrium position
a) In the diagram given here, the Firm obtains equilibrium position at OQ units and
Price OP.
b) At that level, AR < AC, and hence, the difference between AC and AR constitutes
Losses, as depicted by the shaded area.
c) All Firms in the industry which have similar cost behaviour as shown here will be
having losses. But, whether the Firm shuts- down or not, depends on the recovery
of Variable Costs.

CA FOUNDATION
d) These Firms would have a tendency to quit the industry and earn normal profits
graph elsewhere, but they cannot exit in the short-run.
e) Though the Firm is in equilibrium (inspite of earning losses), the industry as a

whole will not be in equilibrium, since the Firms will have a tendency to leave the
industry.
Note: For Losses, AR < AC, at a point where MC = MR (MC cutting from below).
Shut Down Point at the Short Run Equilibrium position
• In the diagram given here, the Firm will be in equilibrium at OQ units and Price
OP.
• But, at that level, AR < AVC, as depicted by the shaded area. Hence, the Firm will
refuse to produce output at that level, since even Variable Costs are not recovered.
This constitutes the Shut-Down Point for the Firm.
• Re-Opening:
a) The Firm will wait for some time for the market situation to improve, and
the Prices to increase.

CA FOUNDATION
b) If more Firms shut-down temporarily in this manner, the supply to the

industry will decrease, pushing up the Equilibrium Price in the industry.
c) These Firms will now re-open once the Market Price (i.e. D = MR = AR) is
equal to or above AVC.
Note: A Firm will shut down, if AR < AVC, at a point where MC = MR (MC cutting from
below).
Long Run Price, Output and Profit Determination

Determination of Long Run Equilibrium of a Firm
In the long-run, Firms will be in equilibrium when they make only Normal Profits. So,
their MC = MR and AC = AR in the long-run.
1) For Long-Run Equilibrium, LMC = LMR = MR (i.e. MR and LMR are the same). Also,
LMC should cut MR from below.

CA FOUNDATION
2) Since only Normal Profits can be earned by all Firms in the long-run, LAC = LAR =
Price.
3) Further, in the long-run, the Firm will choose a Plant that will minimize its cost.
Hence, LAC = SAC3 in the above diagram. Also, SMC3 will cut SAC3 at its lowest
point only. So, we have SAC3 = SMC3.
4) Taking into account, all the above factors, the condition for long-run equilibrium
of a Firm under Perfect Competition is SMC = SAC = LAC = LMC = LMR = LAR =
Price.
5) In the diagram, the minimum point of the LAC Curve, is tangent to the Demand
Curve (i.e. D = P = AR = MR = LMR = LAR). Also, the LMC Curve should cut LMR
Curve from below at this point.
Long Run - Normal Profit only
If existing Firms make Super -Normal If existing Firms have Losses in the short
Profits in short-run. run.
New Firms will be attracted and enter If existing Firms make losses, they will
the industry. leave the industry in the long-run.
So, there will be increase in Supply, So, there will be reduction in supply,
causing a reduction in the Market Price. leading to increase in Market Price.
Further, there will be an upward shift of Also, Cost Curves may fall as the industry
Cost Curves due to the increase in prices contracts, until the remaining Firms in
of factors of production, as the industry the industry cover their total costs,
expands. inclusive of the normal rate of profit.
These changes will continue until the

LAC is tangent to the Demand Curve.

CA FOUNDATION
Thus, Market Forces and Movements in Demand & Cost Curves, ensure that all Firms
earn only Normal Profits in the Long-Run. These Normal Profits are included in AC
itself, and hence the condition LAR = LAC.
Long Run Equilibrium in the Industry
The industry is said to have attained long-run equilibrium when –
• All the Firms are earning normal profits only, i.e. all the Firms are in long-run
equilibrium, and
• There is no further entry or exit of Firms to / from the market.
Conditions / Effect of Long-Run Industry Equilibrium under Perfect

Competition
a) For long-run equilibrium, SMC = SAC = LAC = LMC = LMR = LAR = Price.
b) Output is produced at the minimum feasible cost (i.e. LAC).
c) Plants are used at full capacity in the long run, so that there is no wastage of
resources i.e. LMC = LAC.
d) There will be an optimal allocation of resources.
e) Consumers pay the minimum possible price, which just covers the Marginal
Cost i.e. LMC = LAR.
f) Firms maximize profits (i.e. LMC = LMR), but they will earn only Normal Profits,
i.e. LAC = LAR.
g) Every Firm will be an Optimum Firm (i.e. producing optimum output, at
optimum cost, and earning maximum possible Normal Profits).
h) Market Mechanism (forces of Demand and Supply) ensures optimum
allocation and use of resources in the long-run, under conditions of Perfect
Competition.
Identification of the Supply Curve of a Perfect Competition Firm

CA FOUNDATION
In Perfect Competition, the MC Curve of the Firm (portion above its AVC) will depict
the Firm's Supply Curve. So, for the Firm, S = MC.
MC Curve of a Firm in Perfect Competition
Supply Curve of a Firm in Perfect Competition

CA FOUNDATION
Explanation:
• If Market Price = ₹ 2, the Firm's Demand Curve will be D1. Hence, at this price,
the Firm will supply Q1 output, since MC = MR (i.e. Demand) at this price.
• If Market Price increases to ₹ 3, the Firm's Demand Curve rise upto D2. Hence, at
this price, the Firm will increase output to Q2 output, since MC = MR (i.e.
Demand) at this price.
• As Market Price increases, the points at which MC cuts MR from below also rises,
leading to an increase in the output that the Firm will supply in the Market.
• So, the MC Curve of the Firm will reflect the Supply Curve (i.e. quantities that the
Firm is willing to produce and supply to the Market).
• However, the Firm will not operate in a situation where AR < AVC. Hence, the
portion of MC Curve above AVC, will depict the Firm's Supply Curve.
MONOPOLY
Features of Monopoly

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The features of Monopoly are –
Aspect Explanation
a) The word 'Monopoly’ means "alone to sell". In a

Monopoly, there is only one Seller.
Single Seller
b) If one Producer can produce a product which has no
substitutes and exclude competition, such that he
controls the supply of that product, he will be a
'Monopolists.
Under Monopoly, the distinction between Firm and

Firm = Industry
Industry disappears, since there is only one Seller, and he
constitutes the entire Industry.
• In a monopolistic market, there are strong barriers to

Entry Restrictions
entry of new Firms.
• Barriers to entry could be –
1. economic,
2. institutional,
3. legal, or
4. artificial.
• A Monopolist sells a product which has no close

substitute.
No substitutes
• The Cross Elasticity of Demand for the Monopolist's
Product and any other product is zero or very small.
a) Price Elasticity of Demand for Monopolist's Product is

Elasticity of
less than one.
Demand
b) The Monopolist faces a downward-sloping Demand
Curve,

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Pure Monopoly is never found in practice, except in public utilities like Railways,
Water and Electricity, etc.
Determination of Demand / Revenue Curve
1) Demand Curve of a Monopolist Firm is the same as Market Demand Curve for the
product. (Since Firm = Industry).
2) Market Demand Curve indicates the quantity that the Buyers will be ready to buy
at various prices, and is negatively sloped, i.e. falls from left to right.
3) Hence, Market Demand Curve = Firm's Demand Curve = Average Revenue (AR).
4) If the Monopolist sets a single price and supplies to all Buyers who wish to
purchase at that price, then his Average Revenue and Marginal Revenue Curves
will be as depicted here.
5) Relationship between AR & MR under Monopoly:
• Both AR and MR are negatively sloped (downward sloping) curves.
• MR Curve lies half-way between the AR Curve and the Y-axis, i.e. it cuts the
horizontal line between Y axis and AR into two equal parts.
• AR cannot be zero, but MR can be zero or even negative.

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Monopolist - Price-Maker
1) In Perfect Competition, Firms are Price-Takers, i.e. they take the price determined
by market forces, and determine only their optimum output.
2) However, a Monopolist has to determine Output and also the Price for his product.
3) Since Price and Demand Quantity are inversely related, the Monopolist has to
carefully try to attain the equilibrium level of output, at which his profits are
maximum.
4) Based on the equilibrium level of output, the Price will be determined by the
Monopolist Thus, a Monopolist is a Price-Maker, not a Price-Taker.
Short Run Price Output and Profit Determination

Short Run Equilibrium for a Monopolist Firm
• Conditions: For achieving Equilibrium, the conditions to be satisfied are –

a) MC = MR, and
b) MC Curve should cut MR Curve from below, i.e. MC should have positive
slope.
• Diagram: From the Diagram, Equilibrium Level is the point where MC Curve cuts
MR from below, i.e. when output = OQ units. Hence, the Monopolist will produce
OQ units and sell them at Price OP.
• Profits / Losses: At Short-Run Equilibrium Level, The Monopolist may make - (a)
Super-Normal Profits, or (b) Normal Profits (sometimes), or (c) Losses, which can
be known based on his AC Curve.
Super-Normal Profits/Losses at the Short Run Equilibrium Position
Determination of Long Run Equilibrium of a Monopolist Firm

a) In the long-run, the Monopolist can adjust his Plant Size or use his existing
Plant at any level that maximizes his profit.

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b) Due to absence of competition, the Monopolist need not produce at the optimal
level. He can produce at sub- optimal scale also. This means that the Monopolist
need not reach the minimum of LAC Curve. He can stop at any place where his
profits are maximum.
c) The Monopolist will continue to make super-normal profits even in the long
run, as entry of outside Firms is not possible.
d) However, there can be no losses in the long-run. The Monopolist will not
continue if he makes losses in the long- run.
Price Discrimination
Meaning:
• Price Discrimination occurs when a Producer sells a commodity to different
Buyers, at different prices, for reasons not related to differences in cost.
• Price Discrimination is possible under Monopoly, where the Seller can

influence the price of the product.
[Note: Price Discrimination is not possible under Perfect Competition, since each
Firm has no influence over market price.]
Objectives:
• To earn Maximum Profit
• To Dispose of Surplus stock
• To enjoy Economies of Scale
• To capture foreign markets
• To secure equity thorough pricing.
Examples:
a) Doctors may charge more from a rich patient than from a poor patient, for the
same treatment.

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b) Electricity Rates for home consumption in rural areas are less than that for
industrial use.
c) Export Prices of Products are cheaper than the domestic market selling price.
d) Railways charge different rates from different type of passengers e.g. AC, Non-
AC, Tatkal, etc.
e) Railways charge separate rates for high-value or relatively small-bulk
commodities which can bear higher freight charges, than from other categories
of goods.
f) Subscription Rates for certain Journals is lower in case of Student Readers.
Pre-conditions for Price Discrimination

Price Discrimination is possible only if the following conditions are applicable –
a) Seller's Control:
The Seller should have control over the supply of his product i.e. Monopoly
Power, is required to a certain extent.
b) Market Segmentation:
The Seller should be able to divide his market into two or more sub-markets.
The Market should not be an indivisible whole of Buyers.
c) Differing Elasticity:
The Price Elasticity (e) of Demand should be different in the different market
segments. High Prices can be charged if e < 1.So, when the Monopolist charges
a higher price from such Buyers, they do not significantly reduce their
purchases in response to high price.
d) No scope of re-sale:
The Buyers of low-priced market-segment should not be able to re-sell the
product, to the Buyers of high-priced market-segment.

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Process of Price Discrimination
• MR at Same Price:
Assume that a Monopolist charges a single price of ₹ 30 for his product, and
sells them in two markets A and B, with elasticities of demand 2 and 5
respectively.
• Impact of different MR:

From the above, the following observations can be made –
a) At the same price, MR in the two markets are different, due to difference
in elasticities of demand.
b) MR is more in Market B where elasticity is high.
• Output transfer by Monopolist:

If MR is higher in Market B (with high elasticity), the Monopolist will earn more
profit by transferring some quantity of the product from Market A to Market B.
(b) For every unit of product transferred so, the Monopolist will gain ₹ 24 -₹
15 = ₹ 9
• Effect of Output Transfer:

When output quantity is transferred from A to B, the price in Market A will
increase (due to lower supply) and price will decrease in Market B (due to
higher supply). This means that the Monopolist is now discriminating between
Markets A and B.
• Point of Equality:
The Monopolist will reach a point, when the MR in both markets become equal
as a result of some transfer of output. Then, it will not be profitable anymore
to shift more output from Market A to Market
• Differing Prices:
When this point of equality is reached, the Monopolist will be charging
different prices in the two markets - a higher price in Market A with lower
elasticity of demand, and a lower price in Market B with higher elasticity of

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demand. This practice of charging different prices to different segments is

known as Price Discrimination.
Equilibrium under Price Discrimination

Issues:
A Simple Monopolist charges a Single Price for the whole output, but a Discriminating
Monopolist will charge different prices in different submarkets. In order to reach the
equilibrium position, the Discriminating Monopolist is concerned with three issues –
a) What should be the Total Output?
b) How should the Total Output be distributed amongst the various sub-markets?
And
c) What Prices should be charged in the various sub-markets?
Reasons for Monopolies

Monopoly is caused by "barrier to entry", i.e. other Firms cannot enter the market.
Some reasons for occurrence and continuation of Monopoly are –
• Strategic Control over scarce resources, inputs or technology by a Single Firm,

thereby limiting foe access of other Firms to these resources.
• Developing or acquiring control over a unique product that is difficult or costly for
other Companies to copy.
• Patents and Copyrights given by Government to protect Intellectual Property
Rights and to encourage innovation,
• Governments granting exclusive rights to produce and sell a good or a service.
• Substantial Goodwill enjoyed by a Firm for a considerably long period, which
create difficult barriers to entry.
• Natural Monopoly due to very large economies of scale - Suppose, a Single Firm is
able to produce foe industry's whole output at a lower unit cost than two or more
Firms could. In such case, it is often wasteful (for Consumers and the economy) to
have more than one such Supplier because of foe high costs of duplicating foe

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infrastructure, e.g. Telephone Service, Natural Gas Supply, Electrical Power

Distribution, etc.
• Stringent Legal and Regulatory Requirements that effectively discourage entry of
New Firms without being specifically prohibited.
• Very high initial start-up costs even to enter the market in a modest way and
requirement of extraordinarily costly and sophisticated technical know-how, may
discourage new Firms from entering the market.
• Use of Anti-Competitive Practices or Predatory Tactics, (e.g. Limit Pricing or
Predatory Pricing) intended to do away with existing or potential competition.
• Business Combinations or Cartels (Note: This is illegal in most countries) where
former Competitors co-operate on pricing or market share.
Negative Effects of Monopolies

Some negative effects of Monopolies are as under –
• Higher Prices for Consumers,

• Loss of Consumer Surplus.
• Inability of Consumers to substitute the goods or services, with a more reasonably
priced alternative,
• Transfer of Income from Consumers to Monopolists,
• Restriction of Consumer Sovereignty and reduction in opportunities for
Consumers to consume goods they desire,
• Payment of lower prices by Monopolies to their Suppliers (of goods and services),
i.e. lower Factor Payments,
MONOPOLISTIC COMPETITION
Features of Monopolistic Competition

The features of Monopolistic Competition are -

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Aspect Explanation
There are a large number of Sellers who individually

Large Number of Sellers
have a small share in the market.
The products of different Sellers are differentiated

on the basis of brands. Each Seller tries to attribute
Product Differentiation
peculiar features to his product, so as to meet
Consumer needs.
a) Since Products are differentiated, the Producer

Control over Price
of an individual brand can raise the price of his
product, knowing that he will not lose all the
customers to other brands because of absence of
perfect substitutability.
b) However, since all brands are dose substitutes of
one another, the Seller will lose some of his
customers to his competitors.
a) Sellers try to compete on basis other than price,

e.g. aggressive advertising and publicity, product
improvement and development, better
Non-Price Competition
distribution arrangements, efficient aftersales
service, etc.
b) Price reduction is not resorted to. Such Price
Competition may result in price-wars, which
may throw a few Firms out of market.
Now Firms are free to enter into the market and

Free entry /exit
existing Firms are free to quit.
Each Seller tries to develop Brand Loyalty for his

Brand Loyalty
product.

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Examples: Soap has many brands such as Mysore Sandal, Lux, Rexona, Hamam,
Dettol, Liril, Pears, etc. The variation between the brands gives each Seller a chance
to attract business for himself on some basis other than price.
Short Run Equilibrium
• Conditions: For achieving Equilibrium, the conditions to be satisfied are –

a) MC = MR, and
b) MC Curve should cut MR Curve from below,i.e. MC should have positive
slope.
• Diagram: From the Diagram, Equilibrium Level is the point where MC Curve cuts
MR from below, i.e. when output = OQ units. Hence, the Firm will produce OQ units
and sell them at Price OP.
• Profits / Losses: At the Short-Run Equilibrium Level, the Firm may be making -
(a) Super-Normal Profits, or (b) Normal Profits (sometimes), or (c) Losses, which
can be known based on the AC Curve of the Firm.
Note: In Monopolistic Competition, each Firm –
a) does not have a perfectly elastic demand for its products.

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b) is a Price-Maker, and is in a position to determine the price of its own product.
Short-Run Super Normal Profits Short-Run Losses
Here, the Firm obtains equilibrium A Firm may have losses in the short-run,
position at OQ units and Price OP. when it has a very low demand for its
product and the cost conditions are such
that AR < AC.
At that level, AR > AC, and hence, the But, whether the Firm shuts-down or
difference between AR and AC not, depends the recovery of Variable
constitutes supernormal profits, as Costs.
depicted by the shaded area.
Note: For Super Normal Profits, AR > AC, If the Firm recovers AVC and at least a
at a point where MC = MR (MC cutting part of Fixed Cost, it will not shut down,
from below). since there is some contribution
towards Fixed Costs already incurred.
If AR < AVC, the Firm will shut down.

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Determination of Long Run Equilibrium of a Firm
1. Effect of Super-Normal Profit:

a) If Firms earn super-normal profits in the short-run, there will be an
incentive for new Firms to enter the industry.
b) As more Firms enter, Profits per Firm will decrease as the total demand for
the product will be shared among a larger graph number of Firms.
c) This will happen till all the profits are wiped away and all the Firms earn
only normal profits.
2. Effect of Losses:
In case of losses in the short-run, the loss-making Firms will exit from the market.
This process will continue till the remaining Firms make only Normal Profits.
3. Conclusion:
Thus, in the long-run, all Firms in a monopolistically competitive industry earn
only Normal Profits.
4. Non-Optimum Firm:
a) In the long-run, the Firm has excess capacity, i.e. it is producing a lower
quantity than its full capacity level. In the above diagram, the Firm can

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expand its output from Q1 to Q2 and reduce average costs, since B is the
lowest point on the LAC Curve.
b) However, the Firm will not do so since AR (i.e. LAR or D) will reduce even
more than AC.
c) So, under Monopolistic Competition, the Firm is not an Optimum Firm. Each
Firm will have some excess and unused capacity.
OLIGOPOLY
Features of Oligopoly
The features of Oligopoly are –
Aspect Explanation
a) In an Oligopoly Market, there are few (say 2 - 10)

A Few Sellers Sellers selling homogeneous or differentiated
products.

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b) Oligopoly is sometimes described as

'competition among the few'
a) When the number of competitors is few, any

change in price, output, product, by one Firm will
have a direct impact on the other rival Firms,
who will then retaliate in changing their own
prices, output or advertising techniques, etc.
Interdependence b) So, an Oligopolistic Firm must consider not only
the market demand for the industry, but also the
reactions of other Firms in the industry, to any
major decision it takes. This is the concept of
inter-dependence in decision-making.
a) Various Firms in an Oligopoly have to employ

aggressive as well as defensive marketing
Non - Price Competition & weapons and tools, so as to gain a greater share
Impact of Advertising in the market, or to at least maintain their share.
Costs b) These Firms avoid price cutting and try to
compete on non-price basis. If they engage in
price-competition, there will be a price- war,
which will drive a few Firms out of the market,
since customers will try to buy from the Seller
selling at the cheapest price.
a) Oligopoly relates to Group Behaviour, not of

Group Behaviour
mass of individual behaviour.
b) There is no generally accepted theory of group
behaviour. Each Oligopolist closely watches the
business behaviour of the other Oligopolists in
the industry, and designs his strategies on the
basis of some assumptions of how they behave
or likely to behave.

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Note: Coo! Drinks, Automobile, etc. are examples of industries, where there are only
a few numbers of Manufacturers / Sellers.
Types of Oligopoly
Type of Oligopoly Description
Pure or Perfect Oligopoly It occurs when the product is Homogeneous in

nature, Eg: Aluminum Industry
Differentiated or Imperfect It is based on product differentiation, Eg:

Oligopoly Talcum Powder.
Open Oligopoly New firms can enter the market and compete
with the existing firm.
Closed Oligopoly
Firms’ entry is restricted.
Collusive Oligopoly Few firms of the oligopolistic market come to a

common understanding or at in collusion with
each other in fixing price and output.
Competitive Oligopoly In case of absence of understanding among the

firms and they compete with each other.
When the industry is dominated by one large

Partial Oligopoly firm which is considered or looked upon as the
leader of the group. The dominating firm will be
the price leader.
The market will be conspicuous by the absence

Full Oligopoly of price leadership.

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It refers to that situation where the firm sell

Syndicated oligopoly their products through a centralized syndicate.
It refers to the situation where the firm organize

Organized oligopoly themselves in to a central association for fixing
prices, output, quoto, etc.

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CHAPTER – 5
Business Cycles
BASICS OF BUSINESS CYCLES

Business Cycles
Concept:
a) Fluctuations in aggregate economic activity that an economy experiences over
a period of time, i.e. periods of prosperity alternating with periods of economic
downturns, are called Business Cycles or Trade Cycles.
b) Business Cycles refer to alternate expansion and contraction of overall
business activity as reflected in fluctuations in measures of aggregate economic
activity, like Gross National Product, Employment and Income.
c) A Trade Cycle is composed of periods of good trade characterised by rising
prices and low unemployment levels, altering with periods of bad trade
characterised by falling prices and high unemployment levels.

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Phases: The four distinct phases of the Business Cycle are –

i. Expansion (or Boom or Upswing),
ii. Peak (or Prosperity),
iii. Contraction (or Downswing or Recession), and
iv. Trough (or Depression).
Note: The 'Trend' line indicated in the above diagram, represents the steady growth
line or the growth of the economy when there are no Business Cycles.
Features of Business Cycles
• Business Cycles have distinct phases of Expansion, Peak, Contraction and Trough.
These Phases do not display smoothness and regularity. The length of each phase
is also not definite.
• Business Cycles occur periodically although they do not exhibit the same
regularity.
• The duration of Business Cycles vary. They occur again and again, but not always
at regular intervals, nor are they of the same length. Some Business Cycles have
been long, lasting for several years while others have been short ending in two to
three years.
• The intensity of fluctuations also varies. It is not necessary to have the same
growth rate as in the Expansion Phase of the previous Business Cycle.
• It is very difficult to predict the Turning Points of Business Cycles. No economy
follows a perfectly timed cycle. They vary in intensity and length. There is no set
pattern which they follow.
• Business Cycles generally originate in free market economies. They are pervasive
as well. Disturbances in one or more Sectors get easily transmitted to all other
Sectors.
• Although all sectors are adversely affected by Business Cycles, some Sectors like
Capital Goods Industries, Durable Consumer Goods Industry, etc. are

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disproportionately affected. Compared to Agricultural Sector, the Industrial

Sector is more prone to the adverse effects of Trade Cycles.
• Business Cycles are exceedingly complex phenomena, they do not have uniform
characteristics and causes. They are caused by varying factors. It is difficult to
make an accurate prediction of trade cycles before their occurrence.
• Repercussions of Business Cycles get simultaneously felt on nearly all economic

variables, viz. Output, Employment, Investment, Consumption, Interest, Trade and
Price Levels.
• Business Cycles are contagious and are international in character. They begin in
one country and mostly spread to other countries through trade relations.
• Business Cycles may occur due to External Causes (called Exogenous Factors), or
Internal Causes (called Endogenous Factors), or a combination of both.
• Business Cycles have serious consequences on the well-being of the society.
Phases of Business Cycles
Expansion:
a) This phase is characterized by increase in economic activity, viz. Increase in

National Output, Employment, Aggregate Demand, Capital and Consumer
Expenditure, Sales, Profits, rising Stock Prices and Bank Credit.
b) This phase continues till there is full employment of resources and production
is at its maximum possible level using the available productive resources.
c) Involuntary Unemployment is almost zero. Only Frictional Unemployment (i.e.
due to change of jobs, or suspended work due to strikes or due to imperfect
mobility of labour) or Structural Unemployment (i.e. unemployment caused
due to structural changes in the economy), exists.
d) Prices and Costs tend to rise faster. Net Investment also occurs at a faster pace.
e) Demand for all types of goods and services rises.

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f) There is increasing prosperity and people enjoy high standard of living due to
high levels of consumer spending, business confidence, production, factor
incomes, profits and investment.
g) The Growth Rate eventually slows down and reaches its peak.
Peak:
a) The term "Peak" refers to the top or the highest point of the Business Cycle.
b) In the later stages of Expansion, Inputs are difficult to obtain, as their
availability is less than requirement and therefore Input Prices increase.
c) Output Prices rise rapidly, leading to increased cost of living. This causes
greater strain on Fixed Income earners.
d) Consumers begin to review their Consumption Expenditure on housing,

durable goods, etc.
e) Actual demand thus stagnates. This marks the end of Expansion Stage.
f) Peak occurs when economic growth has reached a point where it will stabilize
for a short time, and then move in the reverse direction.
Contraction:
a) Contraction arises since the economy cannot continue to grow endlessly or

indefinitely.
b) Once Peak is reached, increase in demand is halted and starts decreasing in
certain sectors. There is fall in the levels of investment and employment.
c) Producers do not immediately recognize the pulse of the economy and
continue anticipating higher levels of demand, and so, maintain their existing
levels of investment and production. Hence, there is a discrepancy or mismatch
between Demand and Supply, where Supply far exceeds Demand. Initially, this
happens only in few sectors and at a slow pace, but rapidly spreads to all
sectors.

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d) Producers, after being aware of the fact that they have indulged in excessive
investment and over production, respond by holding back future investment
plans, cancellation and stoppage of orders for equipment’s and all types of
inputs including Labour.
e) Such corrective action by Producers generates a chain of reactions in the Input
Markets and Producers of Capital Goods and Raw Materials in turn respond by
cancelling and curtailing their orders. This is the turning point and the
beginning of recession.
f) Decrease in Input Demand pulls Input Prices down, Incomes of Wage and
Interest Earners gradually decline resulting in decreased demand for goods
and services.
g) Producers lower their prices to dispose off their inventories and for meeting
their financial obligations. Now, Consumers expect further decreases in prices
and postpone their purchases.
h) Due to reduced Consumer Spending, Aggregate Demand falls, generally causing
fall in prices. So, the discrepancy between Demand and Supply gets widened
further. This process gathers speed and recession becomes severe.
i) Investments start declining, Production and Employment decline, resulting in

further decline in Incomes, Demand and Consumption of both Capital Goods
and Consumer Goods.
j) Business Firms become pessimistic about the future state of the economy and
there is a fall in profit expectations which induces them to reduce investments.
k) Bank Credit shrinks as Borrowings for investment declines.

l) Investor Confidence is at its lowest, Stock Prices fall.
m) Unemployment increases despite fall in Wage Rates, due to impact on Factor
Markets.
Trough or Depression:
a) The Contraction or Downturn continues till it reaches the lowest turning point
i.e. 'Trough'.

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b) When the process of recession is complete, the severe contraction in the

economic activities pushes the economy into the phase of Depression.
c) Depression is the severe form of recession and is characterized by extremely
sluggish economic activities.
d) Growth Rate becomes negative and the level of National Income and
Expenditure declines rapidly.
e) Demand for Products and Services decreases, Prices are at their lowest and
decline rapidly, forcing Firms to shut down several production facilities. There
is more bankruptcy and closure of Firms.
f) Capital and Consumer Durable Goods Industry, suffer from excess capacity.
g) Unemployment increases, leaving the Consumers with very little Disposable
Income.
h) There is fall in the Interest Rate, and people's demand for holding liquid money
(i.e.in Cash) increases.
i) Despite lower interest rates, the demand for credit declines due to Pessimism
of Business Firms, Reduction in Investors' Confidence, or possible banking or
financial crisis.
j) At the depth of depression, all economic activities touch the bottom and the
phase of Trough is reached.
Note: Depression is a very agonizing period causing lots of distress. The Great
Depression of 1929-1933 is still referred for the enormous misery and human
sufferings it caused.
How does the economy recover?

a) The economy cannot continue to contract endlessly. It reaches the lowest level
of economic activity called Trough and then starts recovering.
b) Trough lasts for some time and marks the end of pessimism and the beginning
of optimism. This reverses the process.

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c) The process of reversal is first felt in the Labour Market. Pervasive

Unemployment forces the workers to accept wages lower than the prevailing
rates. Producers anticipate lower costs and better business environment.
d) Business Confidence slowly increases, consequently Firms start to invest again
and to build stocks.
e) Technological Advancements require fresh investments into new types of
Machines and Capital Goods. The spurring of investment causes recovery of the
economy. This acts as a Turning Point from Depression to Expansion.
f) Baking System now slowly starts expanding credit, matching with the business
confidence.
g) As Investment rises, there is increase in Production, Employment, Factor
Payments, Disposable Incomes, Consumer Spending, Aggregate Demand, etc.
To meet the Aggregate Demand, more goods and services are produced.
Employment of Labour increases, unemployment falls and expansion takes
place in the economic activity.
Indicators
Meaning:
Economists use changes in a variety of activities to measure the Business Cycle and
to predict where the economy is headed towards. These are called Indicators.
There are three types of Indicators viz.
• Leading Indicators,
• Lagging Indicators, and
• Coincident or Concurrent Indicators.
Leading Indicators:
a) It is a measurable economic factor that changes before the economy starts to

follow a particular pattern or trend.

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b) It represents Variables that change before the Real Output changes, i.e. prior to
large economic adjustments.
c) Examples:
• Changes in Stock Prices, Profit Margins and Profits, Indices like Housing,
Interest Rates and Prices, etc. are generally seen as precursors of upturns or
downturns.
• Value of New Orders for Consumer Goods, Capital Goods, Building Permits for
Private Houses, fraction of Companies reporting slower deliveries, Index of
Consumer Confidence and Money Growth Rate are also used for tracking and
forecasting changes in Business Cycles.
d) Demerits:
• Leading Indicators, though widely used to predict changes in the economy, are
not always accurate.
• Experts disagree on the timing of these Leading Indicators, e.g. it may be weeks
or months after a Stock Market Crash before the economy begins to show signs
of receding. Further, it may never happen.
Lagging Indicators:
a) It reflects the economy's historical performance and changes in these indicators
are observable only after an economic trend or pattern has already occurred.
b) It represents variables that change after the Real Output changes, i.e. measures
that change after an economy has entered a period of fluctuation.
c) If Leading Indicators signal the onset of Business Cycles, Lagging Indicators
confirm these trends.
d) Examples: Unemployment, Corporate Profits, Labour Cost per unit of Output,
Interest Rates, Consumer Price Index, Commercial Lending Activity, etc.
Coincident or Concurrent Indicators:

a) It coincides or occurs simultaneously with the business-cycle movements.

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b) It gives information about the rate of change of the expansion or contraction of an

economy more or less at the same point of time it happens.
c) It coincides fairly closely with changes in the cycle of economic activity, and
describes the current state of the Business Cycle.
d) Examples: Gross Domestic Product, Industrial Production, Inflation, Personal
Income, Retail Sales and Financial Market Trends like Stock Market Prices, etc.
Examples of Business Cycles
The Great Depression of 1930:

• The world economy suffered the longest, deepest, and the most widespread
depression of the 20th century during 1930s. It started in the US and became
worldwide.
• The Global GDP fell by around 15% between 1929 and 1932.
• British Economist John Maynard Keynes regarded lower aggregate expenditures

in the economy to be the cause of massive decline in income and employment.
However, Monetarists opined that the Great Depression was caused by the
Banking Crisis and low money supply. Other Economists blamed deflation, over-
indebtedness, lower profits and pessimism to be the main causes of Great
Depression.
• The Depression caused wide-spread distress in the world as Production,

Employment, Income and Expenditure fell.
• The economies of the world began recovering in 1933. Increased money supply,
huge international inflow of Gold, increased Governments' spending due to World
War II, etc. were some factors which helped economies slowly come out of
recession and enter the phase of expansion and upturn.
Information Technology Bubble Burst of 2000:

• Information Technology (IT) Bubble or Dot.Com Bubble roughly covered the
period 1997-2000.

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• During this period, many new Internet-based companies (referred as Dot-Com

Companies) were started.
• The low interest rates in 1998-99 encouraged the start-up Internet Companies to
borrow from the markets. Seeing vast scope in the growth of Internet, Venture
Capitalists invested huge amount in these companies.
• Due to over-optimism in the market, Investors-were less cautious. There was a

great rise in the Stock Prices of Dot.Com Companies.
• These Companies offered their services or end products for free with the
expectation that they could build enough brand awareness to charge profitable
rates for their services later. As a result, these Companies saw high growth and a
type of bubble developed. However, the collapse of the Bubble took place during
1999- 2001.
• Companies could not sustain long, due to factors like the "growth over profits"
mentality, lavish internal spending, elaborate business facilities without Revenue
Models, etc. The Companies ran out of capital and were acquired or liquidated /
shut-down.
• Stock Markets crashed, and slowly the economies began feeling the downturn in
their economic activities.
Global Economic Crisis (2008-09):

• The recent global economic crisis owes its origin to US Financial Markets.
• Following IT bubble burst of 2000, the US economy went into recession.
• To take the economy out of recession, the US Federal Reserve (the Central Bank of
US) reduced the rate of interest. This led to large liquidity or money supply with
the Banks. With lower interest rates, credit became cheaper and the Households,
even with low creditworthiness, began to buy houses in increasing numbers.
• Higher demand for Houses led to higher prices, and led both Households and
Banks to believe that prices would continue to rise.

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• Excess Liquidity with Banks and availability of new Financial Instruments led
Banks to lend without checking the creditworthiness of Borrowers. Loans were
given even to sub-prime households and also to those persons who had no income
or assets.
• Houses were built in excess during the boom period and due to their oversupply
in the market, House Prices began to decline in 2006.
• The Housing Bubble burst in the second half of 2007. With fall in prices of houses
which were held as Mortgage, the sub-prime households started defaulting on a
large scale in paying of their instalments. This caused huge losses to the Banks.
Losses in Banks and other Financial Institutions had a chain effect and soon the
whole US economy and the world economy at large felt its impact.
Role of Business Cycles in Business Decision Making
1. Demand Impact:
Business Cycles affect all aspects of an economy. So, a proper understanding the
Business Cycle is a must for all businesses, since such Cycles affect the demand for
the Firm's products and also their Profits, Survival and Growth prospects.
2. Policies:
Knowledge of Business Cycles and their inherent characteristics is important for
a Business Firm to frame appropriate policies. The period of prosperity creates
more opportunities for investment, employment and production and thereby
promotes business. The period of recession or depression reduces business
opportunities and profits.
3. Expansion Decisions:
Business Cycles have significant influence on business decisions. A profit-seeking
Firm should consider the nature of the economic environment in making business
planning and managerial decisions, e.g. relating to expansion or down-sizing.
4. Production Aspects:
Businesses have to properly respond to the need to alter production levels relative
to demand. Different Phases of the cycle require fluctuating levels of input use.

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Firms should exercise the capability to expand or rationalize production

operations so as to suit the stage of the Business Cycle. Business managers need
to work effectively to arrive at sound strategic decisions in complex times across
the whole business cycle, managing through boom, downturn, recession and
recovery.
5. Cyclical Businesses
 Business Cycles do not affect all sectors uniformly. Some businesses are
more vulnerable to changes in the Business Cycle than others.
 Businesses whose fortunes are closely linked to the rate of economic
growth are called "Cyclical" Businesses. Examples: House-Builders,
Construction, Infrastructure, Restaurants, Advertising, Overseas Tour
Operators, Fashion Retailers, etc.
 During a boom, such businesses see a strong demand for their products but
during a slump, they usually suffer a sharp drop in demand.
 Some Businesses may actually benefit from an economic downturn, e.g.

when their products are perceived by Customers as representing good
value for money, or a cheaper alternative compared to more expensive
products.
6. Market Entry / Product Launch:
✓ The phase of the Business Cycle is important for a new business to decide
on entry into the market, and determines the success of a new product
launch.
✓ Businesses are required to plan and set policies with respect to product,
prices and promotion, in tune with the stage of the Business Cycle.
CAUSES OF BUSINESS CYCLES
External Causes of Business Cycles

CA FOUNDATION
External Causes (Exogenous Factors) which may lead to Boom or Bust/Contraction

are:
 Population:
If the Growth Rate of Population exceeds the Rate of Economic Growth, there
will be lesser savings in the economy. This will reduce Investment and thereby
lead to reduction in Income and Employment. Due to reduced Employment and
Income, there will be reduced in Consumer Spending and Aggregate Demand
and thus, there will be slowdown in economic activities. The inverse happens
when Rate of Economic Growth is higher.
 Natural Factors:
Weather Cycles cause fluctuations in Agricultural Output which in turn cause
instability in agrarian economies. In years of Droughts or Floods, Agricultural
Output reduces. Incomes of Farmers fall and this reduces their demand for
Industrial Goods. Reduced Food Output leads to increase in Food Prices, and
thus reduces the income available for buying Industrial Goods. Reduced
Demand for Industrial Products may cause industrial recession.
 Technology Shocks:
Growing technology enables production of new and better products and
services. These products generally require huge investments for new
technology adoption. This leads to expansion of employment, income and
profits etc. and give a boost to the economy. Example: Due to the advent of
Mobile Phones, the Telecom Industry underwent a boom and there was
expansion of production, employment, income and profits.
 Wars:
During War times, production of war goods like arms & ammunitions,
weapons, etc. increases and most of the resources of the country are diverted
for their production. This affects the production of other Capital and Consumer
Goods. Fall in production causes fall in Income, Profits and Employment. This
creates contraction in economic activity and may trigger downturn in Business
Cycle.
 Post War Reconstruction:

CA FOUNDATION
After war, the country begins to reconstruct itself. Houses, roads, bridges etc.
are built and economic activity begins to pick up. All these activities push up
effective demand due to which output, employment and income go up.
 International Trade:
Economies of nearly all nations are inter-connected through trade. So,
depending on the amount of bilateral trade, business fluctuations that occur in
one part of the world get easily transmitted to other parts.
 Other Factors:
Changes in laws related to Taxes, Trade Regulations, Government Expenditure,
Transfer of Capital and Production to other countries, shifts in tastes and
preferences of Consumers are also potential sources of disruption in the
economy.
Internal Causes of Business Cycles

Internal Causes (Endogenous Factors) which may lead to Boom or Bust/Contraction
are:
 Price Fluctuations:
The Cobweb Theory propounded by Nicholas Kaldor holds that Business Cycles
result from the fact that present prices substantially influence the production at
some future date.
 Innovations:
According to Schumpeter's Innovation Theory, Trade Cycles occur as a result of
Innovations which take place in the system from time to time.
 Fluctuations in Effective Demand:
a) Effective Demand refers to the willingness and ability of consumers to

purchase goods at different prices.

CA FOUNDATION
b) According to Keynes, Increase in Aggregate Effective Demand causes

conditions of Expansion or Boom and Decrease in Aggregate Effective
Demand causes conditions of Recession or Depression.
c) In a free market economy with Profit Maximization objective of businesses,

a higher level of Aggregate Demand will induce businessmen to produce
more. So, there will be more Output, Income and Employment. However, if
Aggregate Demand exceeds Aggregate Supply, it causes inflation.
d) On the opposite, if the Aggregate Demand is low, there will be lesser Output,
Income and Employment. Investors sell stocks, and buy safehaven
investments that traditionally do not lose value, e.g. Gold, Bonds, etc.
Companies reduce output, lay off workers, consumers lose their jobs and
stop buying anything but necessities. This causes a downward spiral of
reducing prices. The Bust Cycle eventually stops on its own when prices are
so low that those Investors that still have cash start buying again. However,
this can take a long time, and even lead to a depression.
Note: Foreign Demand:

A. The difference between Exports and Imports is the Net Foreign Demand for
goods and services.
B. This is a component of the Aggregate Demand in the economy, and
therefore variations in exports and imports can lead to business
fluctuations also.
 Fluctuations in Investment:
a. Investments fluctuate often because of changes in the profit expectations of
entrepreneurs.
b. New Inventions may cause Entrepreneurs to increase investments in
projects which are cost-efficient or more profit inducing. Investment may
also rise when the rate of interest is low in the economy.

CA FOUNDATION
c. Increase in Investments shifts the Aggregate Demand to the right, leading

to an economic expansion. Decreases in Investment have the opposite
effect.
d. Investment Spending is considered to be the most volatile component of the
Aggregate Demand.
 Fluctuations in Government Spending:

a) Fluctuations in Government Spending with its impact on aggregate economic
activity result in business fluctuations.
b) Government Spending, especially during and after wars, has destabilizing
effects on the economy.
 Macro-Economic Policies: (Monetary and Fiscal Policies)
a) Expansionary Policies, e.g. increase in Government Spending, Reduction in Tax

Rates, Softening of Interest Rates, etc. are the most common method of
boosting aggregate demand. This leads to inflationary effects and decline in
unemployment rates, and results in booms.
b) Anti-Inflationary Measures, e.g. reduction in Government Spending, increase in
taxes and interest rates cause a downward pressure on the Aggregate Demand
and the economy slows down. Sometimes, such slowdowns may be drastic,
showing negative growth rates and may ultimately end up in recession.
 Money Supply:
a) According to Hawtrey, Trade Cycle is a purely monetary phenomenon, since
unplanned changes in supply of money can cause business fluctuation in an
economy.
b) An increase in the supply of money causes expansion in Aggregate Demand and
in economic activities. However, excessive increase of credit and money also
set off inflation in the economy. Capital is easily available, and so, consumers
and businesses can borrow at low rates. This stimulates Demand, creating a
virtuous circle of prosperity.

CA FOUNDATION
c) A decrease in the supply of money may reverse the process and initiate
recession in the economy.
 Psychological Factors:
a) If Entrepreneurs are optimistic about future market conditions, they make
investments, and as a result, the expansionary phase may begin.
b) When Entrepreneurs are pessimistic about future market conditions, the

Investors tend to restrict their investments. With reduced investments,
employment, income and consumption also take a downturn and the economy
faces contraction in economic activities.

CHAPTER – 1 BCK – AN INTRODUCTION
Domains of business and commercial knowledge (BCK)

Domains is defined as a specified sphere of knowledge (in simpler term subject)BCK is
vast
BCK is eclectic (multidiscliplinary)
BCK is ever evolving and expanding
Importance of BCK for Chartered Accountant
❖ Large share of their work arena.
❖ Each business has its own peculiarities and associated variations in notions of
product, inventory, revenue, profit etc.
❖ CA’s can add value to their work if they understand the nuances of the
business.
❖ CA’s can audit diligently, take decisions, strategies, make plans and budgets.
Human activities – economic and non-economic
Economic activities Non-economic activities

All that we do to earn a living comprises Concern for fellow beings, affection &
love for family etc.
Rationality or Self-interest Emotional or sentimental reasons or
altruism
Non-economic activities have an economic dimensions as time money and material are
required
The motive or intent behind any activity defines it as economic or non-economic
Characteristics
activities of Economic activities –
Economic activities are income generating
Economic activities are productive
Even consumption is an economic activity
Saving, investment and wealth
Business as an economic activity
Market oriented production represents supply side of economics
Shift from subsistence driven production towards commercialisation of production.
Broader prospective, business may be defined as an economic activity comprising
the entire spectrum of activities pertaining to production, distribution and trading
(exchange) of goods and services.
In India, agriculture does not comprise industry and hence business.
Medium prospective, business refers to a particular type of activity or industry
Narrow prospective, business may be defined as one’s usual occupation of creating,
owing and actively operating an economic organisation i.e. a firm.
CS Somya Kataria (CS, MBA) (9131993373) Page 1

Layer 1 – commerce (includes all types of economic activity)

Layer 2 – specific type of industry
Layer 3 – daily occupation
Distinguishing characteristics of business vis-à-vis other economic occupations
S. Basis of Business Profession Employment

No Distinction
1. Meaning Entire spectrum Independent Rendering of
of market- rendering of services under a
oriented activities services of contract of
coming specialised nature employment for
under industry, based on prescribed wages/ salaries.
trade qualifications under Also, called
and the aegis of a wages-
commerce professional body employment.
that also prescribes a
code of conduct
2. Mode of Entrepreneur’s Membership of a Letter of

establishment decision professional body and appointment
an certificate ofpractice an
d dservice agreement
other legal
formalities, if
necessary
3. Source of Profit Professional fee Wages and
livelihood salaries
4. Prescribed None Strictly prescribed Minimum
qualification qualification for
each type of job
5. Ethical guidance Founder’s value Professional codes Employer’s codes
6. Investment Substantial Some requirement None
requirement
7. Personal The most you are Quiet a bit Not much
autonomy/freedom own boss
8. Popular Economic Service to the Livelihood
psychologica achievement client/society
l
motive
9. Certainty of Least Quiet a bit The most
income
10 Stability of Uncertain Quite certain Quiet certain
. tenure/durability
of occupation

11 Transfer of Possible Not possible Not possible
. interest/succession
Characteristics of business –
▪ Job creator, not job seeker
▪ Provides momentum to economic growth and development
▪ Investment intensive
▪ Gestation and uncertainties
▪ Systematic, organised, efficiency-oriented activity.
▪ Objective oriented/purposeful
Economic Organic Social objectives Legal, ethical and
objectives objectives environmental objectives
Sales, Survival, Community service, Respect for law in letter and
profits, health, education, health, spirit, fair practices,
return growth, sanitation, heritage transparency, truthfulness,
o diversificati conservation, community honesty & integrity. Green
n on of support during calamities & technologies, product-usage &
investment, capabilities disasters etc. disposal, lower emissions,
efficiency, Specific responsibilities effective waste handling and
economic disposal, preservation of air,
towards employees,
value water and soil quality.
investors, customers,
added
suppliers, competitors etc.
Forms of business organisation

Business ownership is a bundle of rights
Business may be owned singly or jointly
Business may be organised as a proprietary or a corporate concernSole
proprietorship
Easiest and the earliest form Economic hero One-person band
of business
Small scale Enjoy people trust and Unorganized or
provide personalised services informal sector
These enterprises are largest Contribution to GDP, Indirect contribution
Employment and even exports to large suppliers
Products are often Poor working condition Hire and fire policy
derogatorily called ‘local’.
Lack of employee welfare Lack of social and Fate of the enterprise is
environmental concerns linked with the personal
well-being of
the owner.
Relies on personal savings and Obtain micro-finance and Can act as business

assets bank finance facilitators

Keep all profits and bear all
risks
Features Whether merits or limitations
Autonomy of being one’s own boss Merit
Sole provider of capital Limitations
Visibility of the owner and personalised services Merit
Sole bearer of risks Limitation
Unlimited liability Limitation
Fate of going concern Limitation
Succession of ownership By will or application of the law
of inheritance.
Hindu Undivided Family (HUF) Business
Enjoys separate entity HUF cannot earn incomefrom Three successive
status under Income tax salary generations of an undivided
act family are known as HUF
Hindu Succession Act,
1956
Features Whether merit or limitation
Formed by birth in a Hindu Merit
Family pool of resources Merit
Social capital through family involvement Merit
The family members are automatic co- Limitation
owners (called co-parceners) by birth
Decision making is quick Merit
Unlimited liability of the karta Limitation
Fate of going concern Limitation
Succession of ownership By will or application of the law of
inheritance.
Partnership
Contractual co-ownership Agree to share profit Indian partnership Act,
of a business 1932
Agreement Merit
Two or more persons Merit and limitation
Profit sharing Merit
Business objects quite wide Merit

Mutual agency Merit and limitation

Unlimited liability Limitation
Fate as a going concern Limitation
Succession of ownership Limitation
Limited Liability Partnership (LLP)

Liability of partner is Mandatory Designated partner
limited incorporated/registered
Separate legal entity Perpetual succession Hybrid form of business
Limited liability Merit
Incorporation is mandatory Merit
Legal entity separate from its members Merit
Minimum 2 and no limit on maximum number of members Merit
ROC is the administrating authority Merit
Statutory compliances Limitation
Every partner of LLP is only agent of firm merit
Elaborate system of corporate functioning Regulation of capital market

MOA, AOA, prospectus Statutory audit, quarterly audit, listing
Indian corporate sector is numerically dominated by private limited companies
Features of Features of public company
private company
Minimum number of members 2 7
Maximum number of members 200 No limit
Transfer of shares Restricted Freely transferable
Directors 2 3
Committees Exempted Audit committee, CSR committee,
stakeholder
committee and the Nomination
and Remuneration committee
Start business Upon incorporation After certificate of

commencement of business

CHAPTER 2 – BUSINESS ENVIRONMENT
Meaning of Business Environment

According to Gluek and Jauch – “The environment includes factors outside the firm which
can lead to opportunities for, or threats to the firm. Although, there are many factors, the most
important of the factors are socio-economic, technological, supplier, competitors, and
government.”
Characteristics of business environment
Complex Dynamic Multi-faceted
Far reaching impact
Importance of business environment
Determining opportunities Giving direction for growth Continuous learning
and threats
Image building Meeting competition
Relationship between organisation and its environment
Exchange of information
Exchange of resources ( 5 M’s Men, Money, Method, Machine, Material)
Exchange of influence and power
Environmental influences on business
Environmental factors or constraint are largely if not totally, external and beyond the control
of individual industrial enterprises and their managements. These are essentially the ‘givers’
within which firms and their managements must operate in a specific country and then vary,
often greatly, from country to country.
Business functions as a part of broader environment – inputs in different form is converted
into product/services and latter income generated is used for economic growth and
development
Framework to understand the environmental influences
Firstly, initial view of the nature of the organization environment in terms of how
uncertain it is.
Secondly, auditing of environmental influences
The final step, explicit consideration of the immediate environment of the
organization
Why environmental analysis?
To identify the demand of environment and changing its strategy
Utility of environmental analysis
From environmental analysis, strategists get time to anticipate opportunities and to plan
optimal responses to these opportunities. It also helps strategists to develop an early warning
system to prevent threats or to develop strategies which can turn a threat to the firm’s
advantage.

Purpose of environmental analysis

 First, understanding of current and potential changes
 Second, inputs for strategic decision making
 Third, facilitate and foster strategic thinking in organisation
Environmental scanning
Environmental scanning can be defined as the process by which organizations monitor
their relevant environment to identify opportunities and threats affecting theirbusiness
for the purpose of taking strategic decisions.
Events are important and specific occurrences
Trends are the general tendencies or the courses of action along which eventstakes
place.
Issues are the current concerns that arise in response to events and trends.
Expectations are the demands made by interested group in the light of theirconcern for
issues.
Components of business environment
Internal environment – is composed of multiple elements existing within theorganisation,
including management, current employees and corporate cultures.
External environment – these factors that happen outside the business are known asexternal
factors or influences. There are two major types of external environment:
❖ Micro environment
❖ Macro environment
The four environmental influences could be described as follows:
➢ A Strength is an inherent capacity which an organization can use to strategic
advantage over its competitors
➢ A weakness is an inherent limitation or constraint which creates a strategic
disadvantage.
➢ An opportunity is a favourable condition in the organization’s environment which
enables it to consolidate and strengthen its position
➢ A threat is an unfavourable condition in the organization’s environment which
creates a risk for, or caused damage to, the organization.
SWOT Analysis
W T
Using Minimizin Capitalizin Neutralizin
strength g g g
s impact opportunitie threats
S of s
weaknes O
s

Micro and Macro Environment

Micro environment is related to small area or immediate periphery of an organization.
Following issues to be address:
Employee of the firm
Customer base
Finance
Firm suppliers
Local community
Direct competition
Micro environment are specific and short term but regular basis. Micro environmentconsists
of:
Customers Organization Market
Intermediaries Competitors Suppliers
Macro environment has broader dimensions and for long period. The issues are:
o Threat from competitive world
o Technology
o Bargaining/dominance of supplier and customers
Macro environment consists of:
Demographic Political Economic
Social Technological Government
Legal Global
Elements of micro environment
Customers/consumers – according to Peter Druker the main aim of business is to
create and retain customers.
Competitors – may be direct or indirect. Direct means which are in same business
activity, selling the same product, products which are related to each other or are
exactly the same. Indirect means were product/services are different.
Organization – owners, Board of Directors, employees.
Market – key issues are:
 Cost structure of the market
 The price sensitivity of the market
 Technologies structure of the market
 The existing distribution system of the market
 Is the market mature
Suppliers – important component. Organization need to take major decision
regarding ‘outsourcing’ or ‘in-house’ production depending upon supplier
environment.
Intermediaries
CS Somya Kataria (CS, MBA) Page 8

Elements for Macro Environment

Demographic environment –
• Population size (population growth rate and life expectancy rate)
• Geographic distribution (from region to region)
• Ethnic mix (relating to or characteristics of a human group)
• Income distribution (level of individual and group purchasing power)
Economic environment – refers to the nature and direction of the economy inwhich
a company competes or may compete.
Factors that affect the economic environment:
1. Economic systems
Capitalism
Socialism
Mixed economy
2. Economic conditions or factors
3. Economic policies
▪ Industrial policy
▪ Fiscal policy
▪ Monetary policy
▪ Foreign investment policy
▪ Export-import policy (Exim policy)
Political-legal environment –
➢ Government
➢ Legal
➢ Political
Socio-culture environment – some of the important factors and influencesoperating
in the socio-cultural environment are:
Social concerns,
Social attitudes and values
Family structure and changes in it
Role of women in society
Education levels
Technological environment – following factors to be considered:
❖ Pull of technological change
❖ Opportunities arising out of technological innovation.
❖ Risk and uncertainty of technological development.
❖ Role of R&D in a country and government’s R&D budget
Global environment – following factors to be considered:
✓ Potential positive and negative impact of significant international events.
✓ Identification of both important emerging global markets and changes.
CS Somya Kataria (CS, MBA) Page 9

✓ Differences between cultural and institutional attributes of individual

global markets.
PESTLE ANALYSIS
× Political factors are how and to what extent the government intervenes in the
economy and the activities of business firms.
× Economic factors have major impacts on how businesses operate and take
decisions.
× Social factors affects the demand for a company’s products and how that
company operates.
× Technological factors can determine barriers to entry, minimum efficient
production level and influence outsourcing decisions.
× Legal factors affect how a company operates, its costs, and the demand forits
products, ease of business.
× Environmental factors affect industries such as tourism, farming, and
insurance.
Political Economic Social
• Political stability • Economic situation and • Lifestyle trends
• Political principles and trends • Demographics
ideologies • Market and trade • Consumer attitudes and
• Current and future cycles opinions
taxation policy • Specific industry • Brand, company,
• Regulatory bodies and factors technology image
processes • Customer/end-user • Consumer
• Government policies drivers buyingpatterns
• Government term and • Interest and exchange • Ethnic/religious factors
change rates • Media views
• Thrust areas of • Inflation andperception
political leaders andunemployment
• Strength of consumer
spending
Technological Legal Environment

CHAPTER 4 – GOVERNMENT POLICIES FOR BUSINESS GROWTH
• Replacement • Business and corporate • Ecological/environmental

technology/solution law issues
• Maturity of technology • Employment law • Environmental hazards
• Manufacturing maturity • Competition law • Environmental legislation
and capacity • Health & safety law • Energy consumption
• Innovation potential • International treaty • Waste disposal
• Technology access, and law
licensing, patents • Regional legislation
• Intellectual property
rights and copyrights
Strategic responses to the environment

a) Internal strategic responses
Administrative responses – formation or clarification of the organization’s
mission; the development of objectives, policies, and budgets; or the creation of
scanning units.
Competitive response – competitive responses to the environment typically are
associated with for-profit firms.
Collective response – when two or more businesses come together to benefits
from each others advantages, its termed as collective responses.
b) Holistic strategic responses
Least resistance – eg. BSNL Proceed
with caution – eg. Airtel Dynamic
response – eg. Reliance Jio
Policy Framework in India – A historical sketch

Ancient India

 Universities of takhshahila, vaishali and nalanda
 Chanyaka outlined public policy and book ‘Arthashastra’.
 Ashoka introduced the policy of peace and harmony
 Guptas defined policies on taxes, trade and warfare.
 Alauddin khilji introduced stringent tax reforms
 During the time of Akbar, land reforms were introduced
India under the british rule
Dadabhai Naoroji through his seminal work ‘His book Poverty and Un-BritishRule in
India’.
Zamindari system
India since Independence
First industrial policy 1948
Preamble of constitution adopted in 1950
First five year plan in 1951
Industrial policy resolution 1956
LPG policy 1991
Policy regime of mid fifties Policy regime since 1990s
Mixed economy, with dominant public Capitalistic economy
sector
Economic planning Market mechanism
Closed economy policies Open economy policies – towards
globalization
Acquiring commanding heights through State ownership of business as exception;
public sector undertakings privatisation of public sector undertakings
Regulation and control Liberalisation of regulation
Spectre of government policies for business
Economic policies
Macroeconomic
Fiscal policy Monetary policy
management
Agriculture policy
Sector management Industrial policy Foreign trade &
investment policy

Fiscal policies – that is the policies relating to the government expenditure and taxand non-
tax revenue.
Monetary policies – that is policies relating to supply of money, credit and foreign
exchange broadly impact the business.
Sectoral policies - pertain to the specific sectors of the economy.Macro
policy indicators and business conduciveness
GDP, inflation, tax rates, interest rates, and exchange rates are the five most
significant macro policy indicators impact business.
Variable Direction Meaning
GDP Rising Economic optimism; high demand expectation
Inflation Moderate Demand and profit expectation
Tax Lower Incentive for investors in the form of post-tax business
income
Interest Lower Lower cost of funds
Exchange Moderate Protection to domestic production; incentive for exports
Policy formulation and impact transmission process
Policy Policy Institutions Instruments Market/market

contex conten participant
t t
The process is bi-directional.

Types of government policies by intended impact
Protective policies – aim to provide protection to the businessman so that thesemay
sustain themselves and grow. Eg. Inward looking trade strategy Restrictive policies
– put a curb on business growth lest it should becomedetrimental to the interest
of the consumers and public at large. Eg. MRTP actRegulatory policies – policies aim
at putting in place an institutional set up forthe organised functioning of the
relevant activity/market. Eg. RBI Facilitative/developmental policies – are the ones
which facilitates an activity.Eg. MSMEs and NSDC.
The economic change process
Liberalization
❖ Remove or loosen restrictions
❖ Dismantling of licensing and permits, regulation, easing of approvals,
❖ Systematic loosening of legislative and administrative controls over business.

❖ Liberalization may be defined as a systematic process of the enlargement and

enhancement of the freedom of the private sector in the economy.
❖ 18 industries reduced to 3 industries i.e. defense aircraft and warships,atomic
energy generation, and railway transport.
❖ Industrial licensing abolished expect for alcohol, cigarettes, industrial
explosives, aerospace, drugs and pharmaceuticals.
Privatization
Refers to a managerial approach of changing the ownership structure of one or more
government owned institutions.
Higher flexibility and scope of innovation
Enhance market potencies by enhancing efficiency, quality and competitiveness.
Effective tool for rapid restructuring and reforming the public sector.
Delegation – government keeps hold of responsibility and private enterprise handles
fully or partly the delivery of product and services. There is active involvement by
government.
Divestment – government surrenders partial ownership and responsibility andsells
the majority stake to one or more private entities in course of time.
Displacement – the private enterprise expands and gradually displaces the
government entities. Eg. BSNL and MTNL replaced by private sector.
Disinvestment – selling a portion of ownership (stake) in a public enterprise toprivate
parties.
Inward foreign direct investment in India (IFDI)
Foreign direct investment (FDI) may be described as a flow of capital investment to an
enterprise in a nation by another enterprise located in a different nation by capturing a
majority stake in ownership in a company in the target country or by expanding operations
of an existing business in that country.
Where there is no approval through automatic route, the company concerned has to seek
permission from foreign investment facilitation portal (FIFP). Few sectors where FDI is
prohibited under both the government route as well as the automatic route.
▪ Atomic energy
▪ Lottery business
▪ Gambling and betting
▪ Business of chit fund
▪ Nidhi company
▪ Agriculture (excluding floriculture, horticulture, development of seeds, animal
husbandry, pisciculture and cultivation of vegetables, mushrooms etc. under controlled
conditions and services related to agro and allied sectors) and plantations activities
(other than tea plantations)

▪ Housing and real estate business (except development of townships, construction of

residential/commercial premises, roads or bridges to the extentspecified)
▪ Trading in transferable development rights (TDRs)
▪ Manufacturing of cigars, cheroots, cigarillos, of tobacco or of tobacco substitutes.
Foreign institutional investors (FII)

FIIs are large foreign groups with substantial investible funds
FIIs are registered abroad and invest for short period
Investment from India abroad (OFDI)
Indian firms invest abroad too. Eg. Bharti Airtel, PVR cinemas, Sun pharma. Data released
by RBI show that investments by Indian firms in foreign countries in January 2020 rose by
nearly 40% to USD 2.10 billion on a yearly basis.

CHAPTER 5 – ORGANIZATIONGS FACILITATING BUSINESS
Introduction
Business facilitators as a system of arrangements that ease the doing of business. Business
facilitator is defined as intermediary in financial sector. Business facilitator help the
business in several ways some of them are:
Freight forwarder – a person or company who organizes shipments for the business
firms to get goods from the manufacturer or producer to a market, customer or final
point of distribution.
Business incubator – helps create and grow young businesses by providing them with
necessary support and financial and technical services.
Financial accelerator – helps a budding business quickly launch a product and put
in the fast lane of commercial success.
Financial consultant – who advises the business on the various sources of finance-
domestic as well as foreign; debt as well as equity; short-term as well as long-term and
helps it mobilise its requirement too.
Merchandiser – who helps the business.
Non-funding institutions for business facilitation in India (India regulatory bodies)Reserve

bank of India (RBI)
Introduction
RBI was established on 1st April, 1935 in accordance with the provisions of RBIAct, 1934.
Nationalisation in 1949
Rbi fully owned by government
Central office in Mumbai
Role of RBI
Apex monetary institution
Maintenance of economic stability and assisting the growth
Controlling the country’s monetary policy
Advisor to the government
Act as a friend, philosopher and guide to commercial banks
RBI keep inflationary trends under control
Protect the market for government securities
Function of RBI
Issue of currency – not one rupee coins and notes and subsidiary coins
Banker to the government –
➢ Transact all the general banking business of SG and CG
➢ Manages public debt
➢ Treasury bills on behalf of CG
➢ Advances for 90 days to CG & SG
➢ Act as an advisor to government

Banker’s bank – control and supervise commercial banking system

Custodian of foreign exchange reserves
Control of credit
Promotional functions – promoting banking habit among people and mobilising
savings from every corner of the country
Collection and publication of dataRBI’s
role in business facilitation
• Currency policy
• Credit policy
 Statutory liquidity ratio (SLR), Cash reserve ratio (CRR) or Bank rate are
quantitative measures of credit policy
 Discount rate - RBI provides loans to the banks either by direct lending or by
rediscounting (buying back) the bills of commercial banks and treasury bills.
 Repo rate – the rate at which banks borrow money from the RBI against
pledging or sale of government securities to RBI
 Reverse repo rate – it is the rate of interest offered by RBI, when banks
deposits their surplus funds with RBI for short periods.
• Development of the financial system
• Fund transfer and payment mechanism
Securities and Exchange Board of India (SEBI)
Introduction
✓ Established by the government of India on 12th April 1988
✓ SEBI act, 1992 has come into force with effect from 30th January, 1992
✓ Headquarters at district of Bandra Kurla complex in Mumbai.
✓ SEBI consists of chairman, two members from ministry, one member from RBI,five other
members out of which three members shall be whole time.
Functions and responsibility of SEBI
SEBI has to be responsive to the needs of three groups,The
issuers of securities
The investors
The market intermediaries
SEBI has three functions
❖ Quasi-legislative – draft regulation
❖ Quasi-judicial – passes ruling and orders
❖ Quasi-executive – conduct investigation and enforcement
There is securities appellate tribunal consists of three members which is headed byMr.
Justice J P Devadhar.
Powers of SEBI
Approve by-laws of stock exchange

Require stock exchange to amend their bye-laws

Inspect the books of accounts and call for periodical return from stockexchange
Inspect books of financial intermediary
Compel certain companies to list their shares in one or more stock exchange
SEBI’s role in business facilitation
Enables firm to raise funds in the capital market and causes them to instituteeffective
mechanisms of corporate governance.
Competition Commission of India (CCI)
Competition commission was set up to create and sustain fair competition in the economy
that will provide a ‘level playing field’ to the producers and make the markets work
for the welfare of the consumers
i. Direct competition – product that performs the same function compete against each
other. Eg. Coca-cola and pepsi
ii. Indirect competition – products that are close substitute for one another compete.eg.
fine dining restaurant with local restaurant
Benefits of free and fair competition
 Encourages innovations
 Increases efficiency
 Punishes the laggards
 Boosts choice improves quality, reduces costs
 Ensures availability of goods in abundance of acceptable quality in affordable
price.
Features of Competition Act, 2002
Prevent practices having appreciable adverse effect on competition
Promote and sustain competition
Protect interest of consumers
Ensures freedom of trade
The Competition Commission of India (CCI)
× Established by CG on 14th October 2003
× Chairman and six members
Objectives of CCI
o To prevent practices having adverse effect on competition
o To promote and sustain competition in markets
o To protect the interest of consumers and,
o Ensure freedom of trade
Role of CCI
➢ Work for the benefit and welfare of consumers

➢ Fair and healthy competition

➢ Implement competition policies
➢ Develop and nurture effective relations and interactions with sectoralregulations
➢ Effectively carry out competition advocacy and spread the information
Role of CCI as business facilitator
Ensures co-existence of large and small enterprises
Prevents misuse of dominant position in the market against other business
Insurance Regulatory and Development Authority of India (IRDAI)
Introduction
▪ Is an autonomous apex statutory body
▪ IRDAI act, 1999
Mission statement of the authority
To protect the interest of and secure fair treatment to policy holdersSpeedy
and orderly growth of the insurance industry
To set, promote, monitor and enforce high standards of integrity, financial
soundness, fair dealing and competence
To ensure speedy settlement of genuine claims, to prevent insurance frauds andother
malpractices
To promote fairness, transparency and orderly conduct in financial marketsdealing
with insurance
To take action where standards are inadequate or ineffectively enforcedOptimum
amount of self-regulation
Duties, powers and functions of IRDAI
Issue to the applicant a certificate of registration, renew, modify, withdraw,suspend or
cancel such registration
Protection of the interest of the policy holders
Specifying requisite qualifications, code of conduct and practical training for
intermediary
Code of conduct for surveyors and loss assessors
Promoting efficiency in business
Promoting and regulating professional organisation connected with insurance
Laying fees or other charges
Calling for information, enquiry and investigation
Control and regulation of rates, advantages, terms and conditions
Specify the form and manner of books of accounts and statement of accounts
Regulating investment of funds
Regulating maintenance of margin of solvency
Adjudication of dispute between insurers and intermediaries

Supervising the functioning of the tariff advisory committee
Specify the percentage of premium income
Specify the percentage of life insurance and general insurance business
Exercising such other powers as may be prescribed
Role of IRDAI as a Business facilitator
Insurance is an important aid to business and IRDA and ensures that this importantservice
efficiently enables transfer of business risks.
Funding institutions (Indian Development Banks)
Need for day to day operations (working capital)Need
for finance for undertaking (CAPEX)
Industrial Finance Corporation of India (IFCI) in 1948
Industrial Credit and Investment Corporation of India (ICICI) in 1955
Industries Development Bank of India (IDBI) in 1964
National Bank for Agriculture and Rural Development (NABARD)
Apex development bank in India
Headquarters at Mumbai
Bank is entrusted with “matters concerning policy, planning and operations in the field
of credit for agriculture and other economic activities in rural areasin India”.
NABARD discharge its duty –
➢ Serves as an apex funding agency
➢ Takes measures towards institutions buildings for improving absorptive
capacity of the credit delivery system, including monitoring, formulation of
rehabilitation schemes, restructuring credit institutions, training of personnel
etc.
➢ Co-ordinates the rural financing activities and maintain liaison with govt. of
India, RBI and other national level institutions
➢ Undertake monitoring and evaluation of projects refinanced by it
➢ NABARD’s refinance is available to state co-operative agriculture and rural
development banks (SCARDBs), state co-operative bank(SCBs),regional rural
bank (RRBs), commercial bank (CBs)
➢ NABARD is also known for its ‘SHG Bank Linkage Programme’

Introduction To Micro Economics: Economics and BCK Notes

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Introduction To Micro Economics: Economics and BCK Notes

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Economics and BCK Notes

INTRODUCTION TO MICRO ECONOMICS

Wealth related definition–

CS SOMYA KATARIA (CS, MBA) 9131993373 1.1

Science of material well-being “Welfare definition: -

Science of choice making –

CS SOMYA KATARIA (CS, MBA) 9131993373 1.2

1. Concept of welfare is not explicitly mentioned.

2. The definition makes economics a human science instead of social science.

Science of Dynamic Growth and development: - Paul A. Samuelson

NATURE OF BUSINESS ECONOMICS

It analyses the economic behavior of an individual, firm or industry in the national

CS SOMYA KATARIA (CS, MBA) 9131993373 1.3

1. “Micro-economics is the study of particular firms, particular households,

a) It is the study of the overall economic phenomena or the economy as a whole,

b) It analyzes the behavior of national aggregates including national income,

CS SOMYA KATARIA (CS, MBA) 9131993373 1.4

Nature of Business Economics

Based on Micro Economics:

Incorporates elements of Macro Analysis:

Business Economics is an art

Use of Theory of Markets and Private Enterprises:

CS SOMYA KATARIA (CS, MBA) 9131993373 1.5

It is descriptive in nature in the sense that it describes the economic behaviour of

A normative science involves value judgements. It is prescriptive in nature and

Example of positive science:

Example of normative science:

CENTRAL ECONOMIC PROBLEMS

The central economic problem may be of four types:

CS SOMYA KATARIA (CS, MBA) 9131993373 1.6

b) Capital-intensive technique-Under this technique, production depends more

For whom to produce: -

CS SOMYA KATARIA (CS, MBA) 9131993373 1.7

Market Economy or capitalist Centrally Planned Economy or

It is a free economy where central It is an economy under control of the

There is no limit to private ownership of Private ownership of property is under

Maximisation of profit is the principal Maximisation of social welfare is the

Growth of the economy is left to the Growth of the economy proceeds

There is no direct participation of the The government plays on active role in

CS SOMYA KATARIA (CS, MBA) 9131993373 1.8

Features of a mixed economy

Co-existence of private and public sector

Existence of Economic Planning: Allocation of resources in a mixed economy

CS SOMYA KATARIA (CS, MBA) 9131993373 1.9

Administered Price: In a mixed economy, a dual system of pricing exists. In

CS SOMYA KATARIA (CS, MBA) 9131993373 1.10

CS SOMYA KATARIA (CS, MBA) 9131993373 2.1

a) Ceteris Paribus i.e. other things being constant, Demand

a) Complementary Goods e.g. Pen & Ink Price of one good

a) Average Money Income , Demand of Normal good ↓,

Favorable change in taste & Preference increases demand

SNOB EFFECT: A person may develop a taste or preference

CS SOMYA KATARIA (CS, MBA) 9131993373 2.2

VEBLEN EFFECT: Highly priced goods are consumed by

If the consumers expect increase in future prices, increase in

a) Size of the Population- larger the size of population,

d) Consumer-credit facility and interest rates: Availability

CS SOMYA KATARIA (CS, MBA) 9131993373 2.3

level of education, marital status, weather conditions,

Definition by Prof.Alfred Marshall

CS SOMYA KATARIA (CS, MBA) 9131993373 2.4

• Dx = Demand for Commodity

CS SOMYA KATARIA (CS, MBA) 9131993373 2.5